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Dollar Gain Signals Pain; Rally Prompts Exit (Update1)

By Ye Xie and Anchalee Worrachate

Aug. 11 (Bloomberg) -- Just because the dollar posted its biggest gain against the euro in almost eight years doesn't mean the U.S. currency won't continue to be plagued by the nation's slowing economy, widening budget and trade deficits and negative inflation-adjusted interest rates.

The 4 percent surge against the single European currency this month was enough to prompt Bank of America Corp. to tell its customers to exit trades betting on more gains. Morgan Stanley still forecasts the greenback will approach a record low by October as the U.S. housing slump and credit-market losses keep the Federal Reserve from raising interest rates this year.

Barclays Plc in London and New York-based Merrill Lynch & Co. said trading patterns suggest the dollar's 5.1 percent gain in the past three weeks measured by an index of six major trading partners can't be sustained.

That's mostly because there's no indication the U.S. will return to the late 1990s annualized gross domestic product growth of 4.23 percent with inflation running at no more than 3.3 percent. Since September, 2000, the dollar has declined more than 44 percent as inflation accelerated to an annual 5 percent today, growth slowed to 1.9 percent and U.S. interest rates provide no cushion for holding U.S. assets.

``I would not chase the dollar's strength versus the euro as the pair has moved beyond interest-rate support,'' said Sophia Drossos, a strategist in New York at Morgan Stanley, who also recommended closing out bets on the dollar versus the currencies of Malaysia and Singapore. ``The dollar is not out of the woods. It will take the market a while to come around to our point of view.''

Unsustainable Recovery

The dollar strengthened to $1.5005 to the euro last week from $1.5564 on Aug. 1, the biggest weekly increase on a percentage basis since January 2005. It surged 2.08 percent on Aug. 8, touching $1.4998, the most since Sept. 6, 2000, and the second largest rally since the euro was introduced in 1999.

Those gains sent the dollar above the $1.51 per euro yearend mean target of 39 analysts in a survey by Bloomberg. By the end of 2009, the dollar will likely strengthen to $1.40 per euro, based on the estimates. It gained 6.4 percent since hitting a record low of $1.6038 on July 15.

In addition to the gains against the euro, the dollar also appreciated 2.3 percent versus the yen to 110.18, the most in eight weeks. The euro lost 1.29 percent against the Japanese currency to 165.38, the biggest drop in 13 weeks.

U.S. economic data suggest that a sustained recovery isn't imminent, said Robert Sinche, head of global currency strategy at Bank of America in New York. Interest-rate swaps indicate the currency should trade at about $1.54 per euro, said Sinche, who still forecasts that the dollar will strengthen to $1.45 per euro by the second half of next year.

Foreclosures, Deficits

The number of U.S. home foreclosure filings more than doubled in the second quarter from a year earlier, according to RealtyTrac Inc., a seller of default data. Government reports this week may show retail sales fell 0.1 percent in July, the first decrease since February, and the U.S. trade deficit widened in June to $62 billion from $59.8 billion.

The U.S. budget deficit, which totaled $163 billion for 2007, is forecast by the administration of President George W. Bush to widen to a record $482 billion for 2009.

Morgan Stanley predicts the dollar will weaken to $1.60 by October, because the faltering U.S. economy means the Fed is unlikely to raise rates anytime soon, Drossos said. That means investors will continue to suffer inflation-adjusted returns that are negative based on the current annual consumer price index of 5 percent and Treasury securities yielding between 1.695 percent for three-month bills and 4.53 percent for 30-year bonds.

`Particularly Weak'

Rather than a vote of confidence in the outlook for the U.S. economy, the euro's tumble on Aug. 8 was triggered by traders paring bets the European Central Bank will lift borrowing costs after ECB President Jean-Claude Trichet said economic growth will be ``particularly weak'' through the third quarter. Trichet spoke after the central bank left the main refinancing rate at 4.25 percent.

Gross domestic product growth in the euro region is expected to slow to 1.7 percent this year and 1.3 percent in 2009, from 2.68 percent in 2007, according the median forecast in a Bloomberg survey. U.S. GDP will slow to 1.5 percent before rebounding to 1.8 percent next year, another survey showed.

``The outlook is looking certainly brighter for the dollar,'' said Nick Bennenbroek, head of currency strategy in New York at Wells Fargo & Co. ``The most significant factor is that there are now much clearer signs that U.S. economic weakness has spread to global economic weakness.''

`Overshoot Territory'

Wells Fargo forecasts the dollar strengthening to 1.48 per euro by the end of next year.

David Woo, head of currency strategy in London at Barclays, disagrees. ``The euro-dollar market is in an overshoot territory,'' he said. Barclays, the world's third largest currency trader, according to an annual survey by Euromoney magazine, expects the dollar to weaken to $1.57 per euro by year-end.

Dollar bears point to the Fed's decision on Aug. 5 to leave its target rate for overnight loans between banks at 2 percent for a second straight policy meeting. Policy makers said ``downside risks'' to growth remain, while inflation is a ``significant concern.'' Futures on the Chicago Board of Trade show a 38 percent chance the Fed will raise its target rate at least a quarter-percentage point by year-end and a 90 percent probability of higher borrowing costs by the end of March.

`Balance of Risks'

``We still see the balance of risks to the upside for euro- dollar given considerable headwinds facing the dollar and unrealistic pricing for Fed hikes,'' strategists led by Ray Farris at Credit Suisse Group in London wrote in a research note at the end of last week. The dollar may decline to $1.61 per euro by the end of next month and to $1.64 by year-end, they said, the most bearish forecast in the Bloomberg survey.

Traders who look at charts of price patterns say technical indicators suggest the dollar's rally may have been exaggerated.

Losses accelerated Aug. 8 when the euro dropped below $1.53 and broke the 200-day moving average for the first time since April 2006. Currencies typically revert toward their mean price after breaking through averages unless new ranges are established.

Trading envelopes, which measure how far from the mean a price has strayed, show the euro's decline is double the typical changes versus the dollar in the past 20 days, suggesting that the dollar is either establishing a new level or will trade closer to the average price.

`Bit Too Fast'

The 14-day relative strength index fell to 21.82, the lowest since the euro's debut. A relative strength index level below 30 suggests a currency's decline is extreme and a reversal may be imminent.

``We are looking for the euro-dollar to move down over the year, but feel that the current move is a bit too fast,'' said Emma Lawson, a currency strategist in London at Merrill Lynch, which still expects the dollar to rise to $1.48 per euro by January. ``The dollar has started from a position of being undervalued while a lot of these currencies are overvalued.''

Anyone have probs with EUR/USD on ODL MT4. I get a straight graph line on M1 and nothing on M5 or M15

Seems to be OK here on ODL jeff

OK here too, Jeffie.

ok now, slow connection I think

Hil, you have mail.

They're getting all philosophical on the Hub today. Sadly it's the last day for what I consider to be the best website on the whole internet thingey.

Agreed Hil. I shall miss it - I hope they do something similar soon - lots of hints that they might.

Whats "The Hub"

ThomsonReuters FX Hub, Spacie. It's been the best kept secret out there.

thanks Hils, trust me to find out about it as it ends. In fact has it already gone? I cant access it at the mo.

Managed to get in now, what a shame i love the calendar, site si nice and simple and clear, so why are they closing?

How annoying, I closed this morning's cable short earlier and left 3 pips for the next man ;-)

edit and even more annoying, I should have reversed!

Re: The Hub.

ThompsonReuters are in massive post merger/takeover consolidation and cost-cutting mode. Many babies are going out with the bathwater. People I deal with are in fear of their jobs -- slash and burn is the order of the day. Expect no good judgement or even commonsense.

BTW, who's going to get post 10,000? It should be you, Hil . . .

It looks like it's me then. Well spotted, DelBoy.

:o)

Hi all.... 1:8600 area does looks like it might be a Cable reversal point....

10000 posts.... you might have to call this thread a success...
Well done Hils

good 2cu on the thread again foale, currently in uk, just ofto one of those nasty pubs that stays open till you go home!

Don't know if this has been mentioned elsewhere but there's an EWI Freeweek for Forex this week, including intraday:

www.elliottwave.com

NEW YORK (Dow Jones)--Global central banks that kept huge amounts of U.S. dollars as foreign currency reserves throughout the long years of decline will be even more loyal to the greenback now that it's making a comeback, right?

Wrong.

If the dollar is indeed on track for a multi-year uptrend, central banks are likely to slowly cut back on their dollar holdings. And with trillions of dollars sitting in foreign central bank coffers, analysts say that even a moderate reduction in reserves could put the brakes on any major surge by the U.S. currency. That means a long-term upswing in the dollar might be just as slow and steady as most of its downtrend was.

"The surge in central banks' foreign reserves (most of which are held in dollars) has been the flip side of the weak dollar over the past six years," said Chris Turner, currency strategist at ING in London. "If the dollar has begun a multi-year recovery...we could conceivably see a modest drawdown in reserves."

During the dollar's roughly six-year decline, global central banks increased their total foreign reserves from around $2 trillion to nearly $7 trillion, according to data from the International Monetary Fund. The dollar's share of these funds has actually increased, accounting for about 63% in the first quarter of 2008, up from about 55% in late 2001.

But that buildup in reserves may now change, as the dollar appears to have found a floor last month, when the euro hit an all-time high of $1.6040. The dollar has since risen about 10%, with the euro falling to as low as $1.4570 Tuesday.


Rainy Days Are Coming

The dollar reserves accumulated by central banks abroad aren't part of an return-seeking investment strategy. Nor are they necessarily intended as a security blanket, to be used in the event of a crisis. Experts say the massive amounts held by many central banks - about $1.8 trillion in China, $300 billion in India, $200 billion in Brazil - far surpass the amount deemed necessary to fend off financial market shocks.

Instead, many central banks, including those in the Middle East, China and Brazil, have been stacking up their greenbacks to counteract the dollar's weakness. Buying, or removing U.S. dollars from their local economies, has been an exercise in keeping their own currencies relatively weak, which boosts the economy by helping exports. Now, as the dollar starts to look up, there's less need for such central bank intervention.

Also, as commodity prices come down and a global economic slowdown begins to take hold, local governments may want to use at least some of the reserves to pay for public works projects and other job-creating ventures.

The central banks may "now have an opportunity to do something with the reserves," Turner noted.

Some countries are already being forced to part ways with their reserves as their currency feels the early effects of a stronger U.S. dollar.

South Korea's won is trading at a four-year low against the dollar as foreign investors ditch their won bets on worries over a global credit crisis and a slowing economy. The government has been selling dollars to support the won, shrinking its foreign-exchange reserves to the lowest mark in 15 months in July.

Meanwhile, the stronger dollar could also allow the U.S. government to renew pressure on China to allow its tightly-managed currency, the yuan, to appreciate, making U.S. exports to China more competitive. While the dollar was at record lows against the euro and multi-year lows against a host of other currencies, it was rather difficult for the U.S. to complain about China's weak currency.

A stronger yuan would probably have to come by way of less dollar purchases by China, which could stem, if not reduce, the buildup of foreign reserves by the People's Bank of China.

"The heavy purchases of dollars will have to stop at some point," said Robert Scott, global trade economist at the Economic Policy Institute, who said it might require "the mere threat of trade sanctions."

The PBOC doesn't disclose the composition of its reserves but Barclays Capital estimates around 65% are now denominated in dollars, mostly invested in U.S. Treasury bills.