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Dollar retreat warrants caution

The decline in the dollar amid heightened expectations of a further round of quantitative easing (QE3) from the Federal Reserve might create a buying opportunity in the US currency.

The dollar was hit hard after the minutes of the Fed’s August meeting struck a notably dovish tone on Wednesday. They revealed members felt additional monetary accommodation would likely be warranted “fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of economic recovery”.

Moreover, the Fed appeared to reject other unorthodox measures to get the economy moving, implying that more aggressive QE is likely to remain its single policy tool for stimulating the economy.

The news prompted a 10-basis-point drop in US Treasury yields and took the dollar lower.

The dollar index has now fallen 1.5% during the past week, and is down 3% on the month, with much of the damage done on Wednesday night.

Furthermore, it looks vulnerable from a technical perspective, with the dollar index having broken down through its 100-day moving average and fast approaching its 200-day moving average at 80.6.

However, there must be some caution given that the Fed meeting occurred on August 1, ahead of an improvement in US data that might have changed some minds at the Fed about the need for further easing.

Next week’s Jackson Hole speech from Fed chairman Ben Bernanke now will be the focus of market attention, but as Michael Derks, chief strategist at FxPro, notes, how long the dollar’s soft patch lasts remains to be seen.

“Any suggestion that the economy is relatively resilient will curtail estimates of how large QE3 could be, and thereby assist the dollar,” says Derks.

“As such, those contemplating a short dollar position should be aware that the risk/reward past the short term is probably not very high.”

Furthermore, a dollar decline amid falling US Treasury yields plays against the recent trend in the market.

 US 10-year yield and trade-weighted USD

 Source: Ecowin, Citi 

Todd Elmer, FX strategist at Citi, points out that given the relationship between US yields and the dollar has by and large been negative recently, an argument could be made that an extension of the move in yields would be associated with a stronger dollar.

He concedes that US yields and the dollar do not move solely as a function of US developments, with the risks associated with the eurozone sovereign debt crisis also having an influence.

“However, this relationship is consistent with the longer-term pattern of counter-cyclical trade from the dollar and might indicate that risk aversion associated with slower US growth can often drive flight-to-safety buying of US Treasuries and the dollar,” says Elmer.

Past the short-term, there also appears to be limited room for the dollar to fall in response to QE3.

An analysis from Peter Redward, principal at Redward Associates, featured in EuromoneyFXNews last week, shows that implementation of QE3 is not necessarily negative for the dollar, since a QE3 risk premium has been built into market prices.

In addition, it is clear the dollar is not just being weighed down by the “Bernanke put” but also by the new “Draghi put” that the European Central Bank president introduced into the market last month when he said he would do “whatever it takes” to preserve the euro.

The resulting rise in risk appetite has put pressure on haven demand for the dollar. Any sign that Draghi cannot deliver his side of the bargain, and the US currency should recover its losses in short order.

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