Can Dollar Weakness Turn Into a Currency Crisis?

Last updated 11/9/2009 4:51 AM EST (GMT -5) 7 Comments

Boris Schlossberg

Director of Currency Research, GFT

After a mild counter trend rally over the past several weeks, the dollar once again finds itself near yearly lows against most major currencies as the new trading week begins. The currency market continues to like risk pushing the greenback lower against the euro, pound and Aussie on carry trade flows.

The dollar carry trade rolls on without pause as US rates remain inordinately low at 0-25bp with no possibility of rising in the foreseeable future and this dynamic offers currency traders plenty of time to take advantage of interest rate differentials present in the market. The sharp difference between US monetary policy and the rest of the G-20 became evident last week after the Fed left its ultra dovish language in the communiqué noting that economic conditions are, “likely to warrant exceptionally low levels of the federal funds rate for an extended period.” In contrast ECB chief Jean Claude Trichet hinted that limitless liquidity in the 16 member region will soon end as conditions in Eurozone begin to normalize and the central bank removes its 12 month tender offer from the market. The RBA was even more hawkish in its outlook noting in its quarterly statement that its program of gradual rate hikes will continue in 2010.

The Fed meanwhile is unable to help the dollar, hampered in its policy choices by the weak US labor market conditions. US monetary authorities have never raised rates until the unemployment rate has peaked and with Friday’s NFP data showing the jobless rate breaching double digits for the first time in 26 years, the currency market remains convinced that the Fed will be stationary for at least the next six months.

The buck will therefore will remain under pressure, as long as the US economy continues to be the laggard in the G-20 universe. There are only two possible scenarios that will make the dollar rally – risk aversion or material improvement in US labor market conditions. For now the recovery trade in global capital markets continues to maintain momentum as equity investors remain optimistic about the prospects for growth in 2010. There is a very real danger however that risk assets have been priced to perfection. This week the market will get a glimpse as Australian employment data and if the jobless report from Down Under shows a larger than expected contraction the enthusiasm for the Aussie - which has been the poster child for the recovery trade - could very quickly evaporate leading to a broader sell off in risk assets. For the time being Dow at 10,000, S&P 500 at 1100 and EUR/USD at 1.5000 continue to be the key resistance points for the risk trade and unless those barriers are broken with conviction the dollar’s weakness may be limited by risk aversion flows.

On a longer term time frame the dollar will not generate any sustainable rally until US labor conditions begin to improve. Despite the multi-decade high unemployment rate, there were a some rays of hope in last week’s US labor data. Most notably the fall in the weekly jobless claims to 512K suggests that job losses are reaching a nadir. Weekly jobless claims have been the best precursor to the overall US labor trends and if that number falls below the key 500K mark, currency markets could become much more enthused about the prospects of US recovery. In that case the dollar is likely to rally the strongest against the yen as US yields begin to uptick.

For the time being the Fed remains on the sidelines, leaving the greenback to the vagaries of the market, as the buck’s decline remains relatively orderly. If however, the present slow descent prompted by continuous carry trade flows turns into a runaway market against the buck, in other words if dollar weakness decouples from the recovery trade , with the greenback diving in tandem with stocks, the Fed will have no choice but to act more aggressively on the monetary front even at the expense of US economic growth as dollar weakness could then run the risk of turning into a currency crisis. For now the Fed officials are clearly relieved at not having to make such an unpleasant choice.

Comments (7)

jet

November 09, 2009 at 06:05 AM ET

the sterling's interest rates are just as low and the possibility if the BOE raising rates is just as unlikely owever the GBP rallies against ehe USD - Japan's rates are also low and rhe prospects of raising rates just as unlikely tey the USD can not move higher against the JPY - ????? this makes no sence to me

bschlossberg

November 09, 2009 at 08:29 AM ET

UK economy is VERY levered to global capital markets, so when equities rally the pound responds in tandem with risk appetite,

FXDragon

November 09, 2009 at 08:21 AM ET

I guess risk appetite has the upper hand in the game of forex, not interest. You've been in the market a lot longer Boris; did stocks and dollar ever move in the same direction? If so, how did it happen?

bschlossberg

November 09, 2009 at 08:30 AM ET

Certainly in the past when rising stocks were equated with strong dollar - no longer the case. Markets change trends like clothes change fashion

FXDragon

November 09, 2009 at 05:09 PM ET

But what could be the reason behind that change? Could the us gov. want it that way? Weak dollar increases exports and takes stocks higher as well. I heard mutual funds, 401ks or whatever they call it in us rely mostly on stocks. So the only reason fed would raise rates would be inflation, because it would hurt cizitens savings. So how come that trend did not change before? There has to be a reason!

Also when I look at countries holding dollar reserves the most, they are emerging markets like China. Developed nations like US and germany hold the biggest amount of gold. Gold is rising fast and furious! Maybe if we find the answers, we can forsee where the markets will go?!

Dario Fuentes

November 09, 2009 at 03:37 PM ET

FXdragon,
Dollar is being traded risk on/off and not on fundamentals for a while now but eventually this fact can change.

FXDragon

November 09, 2009 at 05:22 PM ET

Based on that rationale, What could be a catalyst to change the current trend between stocks and dollar? I cant see any! Also Europe likes euro high to import gas and oil cheaper. I get obsessed thinking about it after a while:) Throw in ideas...

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About The Author

Boris Schlossberg began his Wall Street trading career more than 20 years ago at Drexel Burhnam Lambert. There, he traded nearly every type of financial product on the market in the U.S., from equities and options to stock index futures and foreign exchange. His innate ability to analyze market information and use it to trade has helped him become an industry-recognized, “go to” trading professional.

These days, whenever the markets move, many organizations turn to Schlossberg for his take on the situation. He is a weekly contributor to CNBC's Squawk Box and a regular commentator for Bloomberg radio and television. His daily currency research is widely quoted by Reuters, Dow Jones and Agence France Presse newswires and appears in numerous newspapers worldwide. Schlossberg has written for publications like SFO magazine, Active Trader and Technical Analysis of Stocks and Commodities. He is also the author of Technical Analysis of the Currency Market and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Kathy Lien. He joined GFT in 2008.