Scenarios: Triggers that could reverse the US dollar’s decline

NEW YORK (BestGrowthStock) – The foreign exchange market (Read more about international currency trading. ) is increasingly uncomfortable with the U.S. dollar’s steep and hasty demise since the start of September and many are now looking for possible triggers that could reverse the slump.

In recent days the greenback has erased some of the decline as investors began to scale back expectations of how aggressive any Federal Reserve quantitative easing program would be after a recent speech by Federal Reserve Chairman Ben Bernanke. But a fear of much bigger recovery in the U.S. dollar remains.

Below is a list of potential triggers that could turn the currency market in more significant way, and some ideas from IFR markets and Reuters FX commentators on how to profit on the change in market expectations.

MID-TERM ELECTIONS

The mid-term elections on November 2 promise to hold more sway over the U.S. financial markets than in many years.

The three possible outcomes include: the mostly likely outcome according to the polls, the Republicans gain control of the House; the Republicans gain control of both House and Senate, or Democrats retain control over both House and Senate.

The risk markets have performed well in recent weeks, with the S&P500 stock index up over 14 percent from late August, mainly on the belief that the Federal Reserve’s second round of quantitative easing (QE2) will jumpstart the economy or the economy will advance on its own. There is also a perception that risk markets fare better if the Republicans succeed in taking the House in the upcoming mid-term elections.

This outcome is largely priced in. However, markets are not priced for Democrats retaining power in both the House and Senate, which some see as a potentially negative development for risk markets. We strongly believe that the normally weak seasonal period for risk in September/October has been held at bay by QE2 and the election prospects. However given the proximity to the year end trade, effectively only a six-week window, if the Democrats retain control we could see a year end melt down in risk markets.

Hedge funds and active portfolio managers that are now long will swiftly slash positions. In fact, a Merrill Lynch prime brokerage report stated that as many as 25 percent of hedge funds will close by year end due to investor outflows or underperformance.

The percentage of real money portfolio managers that are underperforming by hundreds of basis points are near all time highs. Obviously under this scenario the U.S. dollar would soar as few are currently short nor expecting flight to safety/risk aversion.

U.S. Treasury yields would easily take out the December 2008 lows as the prospects for an even larger than expected QE2 total would be certain. (By IFR Senior Rates Analyst Duncan Balsbaugh. The opinions expressed are his own.)

A GRADUALIST APPROACH TO QE BY THE FED:

The market has QE2 totally baked in and just the expectations of QE2 are really damaging sentiment toward the dollar. Meanwhile various Fed governors don’t seem to be on board, with even St Louis Fed’s James Bullard starting to express some reservations, though it seems like the non-voting members are more against. Any backing off on QE2 would cause a sharp correction and we may even see a “sell the rumor buy the fact” type trade even if in fact the Fed does deliver on QE2.

Having said that, the Fed is backed into a corner and the object of QE2 is to devalue the dollar and try to get some inflation going, rather than push bond yields lower. It has been an interesting couple of days for Treasuries and that market seems to be telling us that they realize that that is the Fed’s intention. Imported inflation will of course be bad for US Treasuries in the end. (By Reuters Asia FX Commentator Rick Lloyd, the views expressed are his own.)

LESS FED QE2 THAN EXPECTED

By most accounts the speculative community is extremely short U.S. dollars looking for the Fed to usher in QE with aggression. The IMM data released last week showed speculative shorts ballooning to USD 30.5 billion the week before last, the highest total since mid-June 2008. Any wavering by the Fed in implementing QE or the introduction of a lighter version than the market is pricing in is likely going to see heavy US dollar short covering. Whether the dollar short covering happens before the Fed’s FOMC meeting in November due to comments from Fed officials watering down market expectations, or it comes after a run of better than expected US data, or it is a “sell the rumor/buy the fact” event after the FOMC on November 3, the biggest risk to the dollar downtrend is less Fed quantitative easing than the market is pricing in.

It is interesting to note that shortly after the IMM reported a record short U.S. dollar position back in June 2008 that the US dollar index (Read more about the global trade. ) started trending higher and between August, 2008 and April, 2009 it gained over 25 percent. This was due to the investor devastation caused by the financial crisis and the run into safe-haven US dollars and Japanese yen. The start of a global trade war could have a similar impact on the financial markets and the US dollar. While the overwhelming consensus is a trade war is highly improbable, (as was a financial crisis in the early days of subprime), it can not be discounted while the currency spat continues and escalates. (By John Noonan, Bureau Chief/Regional Director, IFR FX Watch)

MORE BAD NEWS OUT OF EUROPE:

At the moment the focus is all on the U.S. dollar but what about the euro?

QE2 by the Fed and thoughts of a mini-Plaza Accord have allowed the markets to ignore the fact that Europe still has structural issues to deal with when it comes to fiscal outlook. The divergence seen in the eurozone PMI data suggests that the growth outlook is a factor that one cannot ignore for the peripheral eurozone countries and with mounting labor unrest the risks should not be taken lightly.

The potential for Eurozone related issues to come back on the radar screen is high. Bear in mind that while Ireland is out of the market when it comes to bond issues, they still have to deliver what could be a very tough budget where cuts beyond the initially planned 3 billion euros will need to be delivered.

This could prove to be a euro centric catalyst for a slump in the euro. There are two possible ways to play it: 1) via a lower Euro/Swiss franc, as well as; 2) via a lower Euro/Australian dollar. The key here is that euro zone centric concerns will not stop the market from rushing for hard assets such as the Australian dollar and Swiss franc. Look to buy a slightly out-of-the money euro put option either against the Swiss franc or Australian dollar with a knock-out above 1.35 on EUR/CHF and 1.4275 on EUR/AUD. (By Peter Stoneham, Global Managing Analyst, FX, IFR Markets)

(Editing by Chris Sanders)

Scenarios: Triggers that could reverse the US dollar’s decline