Dollar rebound

As an American graduate student in London over the past 10 months, I am painfully aware of the weakness of the US dollar. Naturally, the month I return to the states, the dollar rebounds.

There is quite a bit of debate as to whether the dollar's 7% rise against the euro over the past month, and yesterday's two year high against sterling, represents a fundamental reversal in the greenback's fortunes. Most analysts are sceptical, citing continued financial market instability and real economy weakness as a threat to any dollar rally. However, I tend to agree with the belief that recent movements signal a long-term (but measured) movement upward.

Currency trading is driven by technical barriers, new data, and moving averages, and by these criteria the dollar has broken key resistance points over the past few weeks. The euro fell below the psychologically important $1.50 level last week, and appears to have carved out a top against the dollar. The Euro is further undermined by a gloomy economic outlook, with the eurozone contracting 0.2% in the second quarter. It is the first quarterly contraction since the euro's introduction 10 years ago. Despite the poor outlook, most analysts expect the single currency to hold up pretty well, hovering around $1.45-$1.50. The ECB is less likely to raise rates than they were 3 months ago, with inflation moderating in the medium term and growth slowing sharply.

Sterling is getting slaughtered. Mervyn King, BoE governor, is in the unenviable position of balancing peaking inflation and a rapidly deteriorating economy. King's comments yesterday indicated to many a dovish stance on inflation, and traders are now pricing in an interest rate cut by Q1 2009. He ominously spoke of "a feeling of chill in the economic air". He has retained rate flexibility, but indicated the economic outlook was the most challenging of his tenure. In response, sterling plummeted to 22 month lows against the dollar, and has crashed through its 200 week moving average, a significant technical trend. Expect GBP/USD decline throughout the year.

A dollar rebound is not guaranteed, and a number of forces are working against the US currency. The dollar's recent turnaround is driven mainly by traders repositioning, with little new money entering the trade. Furthermore, a recent survey by Barclays Capital of Japanese bond investors, among the largest dollar holders, indicated strong scepticism of the dollar's medium-term strength and the real economy outlook for the US.

But two non-technical trends will help sustain this turnaround: 1) the weakness of the dollar, slowing growth in Asia/contraction in Europe, and "cheap" US companies should lead to a foreign buying spree of under-valued US corporate assets. This M&A activity would boost the financial markets and strengthen the dollar. 2) For all of its underlying weakness, the dollar is still the safe-haven of choice for investors around the globe. The S&P 500 (-12% ytd) has outperformed the BRIC markets year-to-date, as the commodity bubble bursts and hot money withdraws. When faced with global recession and inflationary pressures at 20-year highs, investors are still going green.