Dollar Bounce, but Not Real Thing

The US dollar is broadly higher as the correction seen before the weekend was extended through the Asian session. In Europe, the greenback’s gains have been pared, but it remains above last Friday’s high against the major currencies. The exception is the yen, against which the dollar has been confined to roughly JPY81.00-JPY81.50.

The dollar’s bounce looks to be more a function of market positioning and a bout of profit-taking more than a fundamental-driven development. While we anticipate the dollar making low in the first half of Q4, as the Fed’s QE and the normalization of euro zone money market conditions are discounted, this dollar bounce is not being confirmed by interest rate developments and we are suspicious of its sustainability.

We now know that speculators at the IMM began lightening up on their long currency positions in the week that ended last Tuesday. While the euro and sterling made new highs on Friday last week, this was not matched by the Swiss franc and Australian and Canadian dollars. Some observers are highlighting in Bernanke’s pre-weekend speech the recognition that a further substantial expansion of the Fed’s balance sheet could erode confidence in the Fed’s ability to enact a credible exit strategy. Yet there seems to be little recognition of this in the US debt market were US yields are lower.

One of the key fundamental factors that we have argued encapsulates the various forces at work, driving the dollar lower, has been short-term interest rate differentials and the US 2-year yield is holding just above last week’s low just below 35 bp. Meanwhile short-term euro zone rates are rising. Three month Euribor has now reached the ECB’s main interest rate (1.0%) for the first time in 15-months today. This is seen as largely reflecting the ECB’s exit strategy, encouraging banks to reduce their reliance on special liquidity provisions. The US-German 2-year spread is at 50 bp today, which favors Europe the most since late last year.

Ideas that a rift in the ECB has undermined the euro are likely an exaggeration. It is well known the BBK’s Weber and Stark did not support the ECB buying sovereign bonds. Clearly a majority did and does. Weber is in the minority, but pressed his case at the end of last week. While this spur talk about the significance that Weber is seen as a lead candidate to replace Trichet (terms expires in the end of Oct 2011). If anything Weber’s hawkishness, one would have expected, would be euro positive on first blush.