Still there are more than enough signals out there that are making currency traders increasingly worried that the dollar selloff is all but overdone. To name a few; the Japanese yen is at a 14-year high against the dollar, gold is near $1200 an ounce, and the stock market rally has factored in too strong a recovery in global economic growth and corporate profitability.

While long-term declining trend in the dollar is a reflection of large US fiscal and trade deficits and diversification of assets portfolio by large investors, the recent losses have more to do with the US monetary policy adopted to help the country climb out of its worst financial crisis in decades.

The US Federal Reserve has a low interest rate policy, with its benchmark rate at virtually zero, and has consistently shown intention of sticking to the policy as long as it thinks it is needed. What it essentially means is that the US central bank is doling out money for free, allowing its troubled banking sector to repair their balance sheet and encourage investors to borrow dollars at virtually no cost and buy riskier assets like equities. The policy has worked as banks have started to return to profits and the stock market is rallying. According to recent estimates, some $400 billion has left the US money market funds so far this year.

But as part of unintended consequences of the policy, the dollar has become a carry trade. A currency carry trade is a strategy in which investors borrow a currency with low interest rate and buy a currency, which yields a relatively higher interest rate. The strategy allows investors to capture the difference between the rates and make a substantial return depending on the amount of leverage used.

The Japanese drove their rates down to almost zero in the 1990s. By early 2007, it was estimated that the yen carry trade was over $1 trillion. But when the credit crisis hit the world in 2008 and the Fed went for the zero-rate policy, the world wanted dollars. Investors paid back the yen and bought dollars, driving the yen higher and killing the yen carry trade and along with it the so-called “strong dollar” stance of the US government. The distressed dollar has become a political football in the US and has started to taint its relationship with trading partners, but senior Japanese officials have indicated no intention of intervening.

The Dollar Index, which shows the value of dollar against a basket of other major currencies, slid as much as 1.1 per cent on Wednesday after Fed officials described this year’s drop in the currency as “orderly,” signaling it will tolerate a weaker greenback. The comment would, of course, fuel more demand for higher-yielding assets and commodities like gold and oil. The Dollar Index continues to trade around its lowest levels in 15 months. The Fed statement was in line with what its Chairman Ben Bernanke said a few days earlier. Bernanke said that the Fed does “watch the dollar’s value”, but did not say if it was concerned about the declining trend.

Still the activity in the options market, valuation measures and a slight divergence in the tight relationship between stocks and the dollar suggest a possible end to dollar weakness. The most convincing argument of a rebound is the growing nervousness that the rally in riskier assets is overdone.

A lot of good news is already factored in, and the market seems to be looking for something really significant to go selling dollars to buy stocks, commodities and higher-yielding currencies — a popular trade of late, as low US interest rates and an abundance of liquidity have lured investors into riskier assets in search of returns. Some analysts expect the dollar to rebound, as investors take risk off the table and close out their bets against the currency. This phenomenon is called a short-squeeze where an asset rises not because of a fundamental change in view, but just because investors want to take profit on their positions.

Bernanke’s comments were backed by European Central Bank chief Jean-Claude Trichet, but analysts caution that without a change on the policy front, the impact of verbal attempts to talk up the dollar are likely to be short-lived. To be sure, the dollar still has room to fall. Despite its losses so far, the greenback remains above its record low against the euro at $1.6040 set in July, 2008. Speculative positioning data also shows that dollar shorts are not at extreme levels, and more good economic news could hasten more bets against the greenback.

In the near-term, the currency market might likely continue to trade off stocks. Dollar weakness has increasingly become a catalyst for US equity rallies, which look unsustainable given mixed economic news and the recent struggle in oil prices. But now, there are some who ask whether there is a dollar carry trade. In the last nine months, the correlation between dollar and stock market has gone to about 90 per cent. If the dollar rises, the stock markets and other risk assets tend to fall, and vice-versa. It would appear that investors and funds are borrowing cheap dollars on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.

We have seen the steepest rise in US stock markets coming out of a recession since the end of the last world war. The market is “discounting” a 5 per cent GDP next year and a profit rebound beyond anything in past experience. Depending on the quarter, operating earnings are expected to rise by anywhere from 30 to 40 per cent. Price-to-equity ratios are back at 23, well above the 17 we saw in the summer of 2007.

What happens if world trade picks up, as it appears to be doing although gradually now. Admittedly, it is not a robust recovery as yet, but it is rising. That means more need for dollars, adding to what is being borrowed on the assumption the dollar will continue to fall.

Over time, the case for the dollar is not as good as one would like. But in the meantime, we could have one very vicious dollar rally, which would take equity markets down worldwide, along with other riskier assets and commodities. If not on an economic view just because of a major short squeeze. Whenever sentiment gets too strong in one way or the other, it is usually setting up the markets for a rally in the despised asset. Markets usually tend to do whatever can cause the most pain to the largest number of people.

No one is predicting a near-term crash or imminent precipitous bear in the stock market, although in this environment anything can happen. But warnings out there are about an imbalance in the system. The longer this imbalance persists, the more likely it is that the dollar trade and the stock market rally will end in tears.

Ovais Subhani is Executive Editor of 
Khaleej Times and can be reached
at ovais@khaleejtimes.com