BizAnalyst Network: FX: Myriad of factors behind dollar's sudden drop

Saturday, March 01, 2008

FX: Myriad of factors behind dollar's sudden drop

The dollar's drop this week was widely attributed to grim U.S. economic data and Federal Reserve Chairman Ben Bernanke's remarks suggesting more interest-rate cuts are coming.
Those factors, however, tell only part of the story.

Momentum trading, the break of key options barriers and technical levels, and crosscurrents with oil and other commodities all played a role in beating down the buck.

Take, for example, momentum trades, which are market bets made simply on direction rather than fundamentals or intrinsic values. Analysts say the dollar's rapid rise against the euro this week was due in part to this strategy.

"When prices roll higher -- or lower -- and momentum kicks in, the trend attracts fresh interest from momentum traders and models," said Andrew Wilkinson, senior market analyst at Interactive Brokers.

"If you use something like a longer term chart -- weekly -- and use a particular technical indicator, they often create strong cross-overs on a weekly basis, which tend to kick momentum models up and running," Wilkinson said.

Momentum strategies replacing carry trade
Momentum trading played a part in the dollar's drop against the yen Friday to a three-year low of 103.66 yen. See Currencies.

Last year, the dominant theme affecting dollar/yen trading was the carry trade, in which traders borrow lower-yielding currencies (such as the yen) and invest them in assets denominated in higher-yielding currencies (such as dollars). Such positions pressured the yen, because at 0.5%, Japan's benchmark interest rate is the lowest in the developed world.

Such trades usually lose their popularity as risk aversion rises, and traders, fearing losses, liquidate their positions. The unwinding of the yen-carry trade has helped strengthen the yen despite Japan's still-rock-bottom interest rates.

"For the most part, it seems as if the recent price action in the currency market can be better explained by the momentum strategies than carry trades," Marc Chandler, head of currency strategy at Brown Brothers Harriman, wrote in a report.

Momentum trading strategies also help explain the euro's rise to $1.5239 earlier Friday, its loftiest level against the dollar since the European unit began trading in January 1999.
The euro pushed above the $1.4900 three times in the past. But this time, Chandler said, speculators appeared to have less exposure to the European currency and were therefore forced to buy euros to cover their positions after the euro finally broke $1.50 in early Asian trade Wednesday.

"Many, like ourselves, were perhaps lulled into a bit of complacency by the clearly identifiable trading range which had confined the euro for the better part of four months. Until it didn't, and then various types of participants, acting like momentum traders, had to scramble and chase the euro higher," Chandler said.

Options, oil and gold
The $1.50 level was key for the euro because of the currency option positions that were said to be clustered there. Such options are traded in the interbank market, so there was no way to determine the exact size of the positions, but analysts said they were considerable.

Because such options lose their value if a currency touches the strike price, traders holding them buy or sell currencies to defend their positions. When the barrier options -- bets on a specific price -- give way, they create a spike above the knock-out price.

"Options are usually a key factor in determining the intensity by which currencies break full figures, and the break of $1.50 was definitely a case in point," said Ashraf Laidi, chief foreign exchange strategist at CMC Markets US.

"Once the dollar-selling intensified, those traders whose interest lied in protecting the $1.50 level to maintain the validity of those options failed to do so, hence accelerating the euro jump," he said.

"However, we should not ignore the effect of record highs in gold and oil as essential drivers of the dollar decline," Laidi said.

Crude oil and gold are both traded in dollars, so as the dollar declines in value, so does the price of these commodities in non-dollar terms, making them more appealing to speculators. Therefore, commodities prices rise in dollar terms as the dollar falls in value against other currencies.

Crude-oil futures closed modestly lower Friday, after hitting a record high of $103 a barrel overnight and marking new intraday highs for four consecutive sessions. See Futures Movers.
Gold futures finished with gains Friday, after hitting a record high of $978.50 an ounce overnight. See Futures Movers.

If the dollar continues to weaken and U.S. inflation rises, some analysts believe gold could surpass the psychologically key $1,000 level before the end of March. Read more about gold.

Rates still matter
To be sure, economic fundamentals remain as important as ever.
Some economists believe a U.S. recession has now begun, based on data showing declining employment, weak incomes and slumping industrial production. For the current quarter, economists are predicting no growth.

Now that Bernanke has signaled more rate cuts on the horizon, some central-bank watchers predict the federal funds rate will drop to 2% from the current 3%, most likely by the summer. See Capitol Report.

Lower interest rates erode the returns on dollar-denominated assets and can weigh on a currency, as can slower economic growth.

"Mounting recession fears on dour U.S. data and Bernanke's testimony have sent the dollar lower against most major currencies," John Rivera, currency analyst at Forex Capital Markets, told clients in a note Friday.

And the bottom line is that most traders base their actions largely on what they think other traders are doing.

"One of the most powerful market forces and the one we pay close attention to is traders' perception," said Adam Hewison, president of INO.com, a technical analysis site. "Traders' perception right now is to be long commodities, short the dollar, and short the equity markets. That's the way we think the markets are going right now."

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Labels: dollar value, foreign exchange, forex, FX, interest rates, USD