2 January 2005

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Goldilocks has been skipping around the forest, breaking and entering into new highs everywhere, not even cautious anymore - where are the bears?

Not much more than two months ago, it was hard to turn anywhere without bumping into a dollar bear or three; six months ago, they were everywhere; and eighteen months ago, as we all know (but don't like to remember), nobody knew what a dollar bull was.

The chart overleaf will refresh your memory. In October 2004, the dollar was at 1.27 to the Euro and about 117 yen; everybody, his brother, sister and maiden aunt who had been in a wheelchair for three decades had no doubt that the dollar had to fall further. The trade deficit was unsustainable and, while growth was good, it was one of those employment-free recoveries and the Fed's focus on "removing accommodation" in the credit markets was bound to burst the housing bubble sooner rather than later, consumer spending would collapse and all hell would break loose. And, of course, the dollar would fall.

Interestingly, the dollar did fall after that, reaching 1.36 by year-end, after which it turned, snorted, stomped its hooves and took off.

Despite this, it took a while before anyone in the market recognized this new creature. There's an old adage that goes: If it looks like bull, and it smells like bull, and - heaven forbid - it tastes like bull, it must be bull.

But it took a while for anybody to turn into a dollar bull. By mid-2005, the dollar had surged by about 14% to 1.20 (to the Euro), bringing the inscrutable Chinese out of hiding and [closer] to the real world. And lo and behold - there was a flurry of births of dollar bulls.

Since then, of course, the bulls have been scratching the dirt and bucking wildly, but they haven't really been able to get much farther. At its peak, the dollar hit 1.1650, a mere 3% higher than when the bulls were born, and currently, it remains indeterminate - as at the start of any calendar year - around 1.1850, where it has been hovering for about three months.

While sentiment is not dramatically one-sided, it does appear that the majority opinion is looking for further dollar gains, at least into the first quarter - and possibly the first half - of 2006. It is clear, say those that know, that U.S. growth is stronger than expected, and that the Fed will continue to inch rates up, perhaps taking the funds rate (currently at 4.25%) to 4.75% or even 5%. That this may lead to an inverted yield curve - where the long end of the curve is lower than the short end - is, of course, the Greenspan conundrum. The yield curve did invert (1 basis point between the 2 year and the 10 year) briefly, but this could well have been the impact of thin year-end markets, so is not really being taken too seriously just yet. But if the curve does invert, might it suggest - as it so often does - that growth is likely to slacken?

So say the naysayers. They also point to the likelihood that the European Central Bank may - indeed, will - raise rates sooner rather than later. The forward curves (for interest rates) indicate that markets believe that the yield advantage in favor of the U.S. is expected to decline over the next six months. And then, of course, there is the burgeoning U.S. current account deficit, that people seem to have forgotten about. And again, there is the concern that the dollar's recent strength, such as it was, may be the result of repatriation of profits of U.S. companies abroad to take advantage of the National Homeland Security tax benefit, which ended on Dec 31, 2005.

But, despite all this, most analysts are highly upbeat about the U.S. economy and believe that it will continue to attract adequate foreign capital to cover the deficit. Indeed, the vast majority of forecasts call for a 10% rise in the Dow during 2006. Which also suggests that they believe the dollar ain't going very far down any time soon.

So, despite much hard evidence to whet the case of dollar bears, it's hard to find too many of them around. There's nobody - or nobody I've met - who's talking about 1.30 or 1.35 to the Euro. On the other side, dollar bulls are also relatively quiet, holding nervously on to their long positions. On balance, I would say that the year starts favoring a strong dollar, but it lacks conviction.

So, where do we go from here?

Returning to the theme of this piece, the fact is that you will find some dollar bulls around but no real bears. What does this mean? Well, reverting to the time-honored notion that markets will always act to make fools out of the largest numbers of people, the first conclusion is that it's not yet time for a turnaround - there aren't sufficient numbers of players in a position to get hurt. Logically, then, it would seem that the dollar will need to continue to strengthen - irrespective of the reduction in the yield advantage, no progress on the deficit, what have you - till it reaches a level at which everybody piles onto the dollar bull bandwagon. [We are picking this direction since the market is already slightly skewed towards dollar strength.]

Of course, it will run a volatile course - perhaps bouncing around in the 1.16 to 1.23 range for a few months - before it surges higher. A break of 1.16, or, better yet, 1.12 would probably signal a dollar Pamplona, when there will only be bulls in sight.

And if, at that time, you ask, "Where are the dollar bears?", they will look at you as if you are a slightly retarded relative and ask, "What is a bear?"

That will be the time to sell dollars.

Of course, I don't know when it will happen, but it will.

Till then, playing the range may be a good idea. And when the dollar does break higher - and it will move awfully fast when it does - make sure you are long dollars.

The turnaround, when it comes, may well be at levels as high as 1.05 (to the Euro), but since it takes the market some time to shift gears, you will likely have some time to exit your long positions.

Six month Euro puts at 1.10 (at a premium of less than half a cent) or 1.12 (a bit over half a cent) may be a good speculative play.

Currency Markets View: Rupee and Majors

INR

Fortightly movement: O-45.34 H-45.42 L-44.92 C-45.04
Sentiment: Basically bearish, but supported by tight money market
Expected range for 1 month: 45.00 - 45.75
Expected range for 3 months: 45.00 - 46.50

Rupee extended its corrective gains and strengthened 30 paisa during the fortnight before closing at 45.03/04. Heavy foreign fund inflows, liquidation of long Dollar positions because of tight (Rupee) liquidity were the main factors that helped Rupee to extend the huge corrective rally that was sparked off in the beginning of December (on year-end profit taking liquidation of long Dollar positions especially against the Japanese currency). Foreign funds pumped in more than USD 2 billion taking their total investment to USD 10.7 billion in the calendar year 2005.

The USD 7 billion plus of IMD redemption did not affect the Dollar demand as the Central Bank trimmed its bulging reserves to make its commitments but it took its toll on the demand-supply equilibrium in domestic money markets, pushing call rates beyond 7%. Many market makers had to sell long dollars they were holding to fund their rupee requirements. It is significant that most banks were holding dollars long; this suggests that once the liquidity constraint is out of the way - and certainly the IMD redemption will assist that process - we could see banks build up dollar positions again.

With RBI working overtime to help the money markets calm down (suspending MSS temporarily, injecting money through repo auctions), and with the increasing current account deficit a key driver, we expect sentiment to turn negative (for the rupee) again. Of course, immediate movements also depend on how the dollar performs overseas - if it does remain in a narrow corrective range prior to a strong surge, the rupee will likely stay sub-46 for some time.

EUR

Fortnightly movement: O-1.2032 H- 1.2036 L-1.1778 C-1.1836
Sentiment - quite good and may probably improve
Expected range for 1 Month: 1.1750 -1.2300
Expected range for 3 Months: 1.1600-1.2600

The euro closed below the 1.1875 support very early on during the last fortnight following a stronger than expected rise in US housing starts which reinforced expectations of further Fed tightening. Some of the dollar strength may also have been due to final, year-end repatriations by US companies under the Homeland Investments Act. However, the euro has managed to stay over the next support level at 1.18, at least on a closing basis, on expectations of further ECB rate hikes.

But for the thin year-end market conditions, the euro's decline below 1.1875 would have probably meant that the preceding rally to 1.2060 was a false break. It would now seem that the jury will be out for a week or so till normal trading resumes. We still believe that the euro will resume its corrective rally to 1.23 enroute to 1.26. However, a failure to rise decisively over 1.19 this week may probably target 1.16 before the corrective phase sets in.

GBP

Fortnightly movement: O-1.7720 H- 1.7730 L-1.7131 C-1.7228
Sentiment: not quite good but will likely improve
Expected range for 1 Month: 1.7050-1.8000
Expected range for 3 Months: 1.7050-1.8300

Amongst the euro, sterling and the yen, sterling lost the maximum ground against the dollar. It lost 1.5 cents against the dollar after Bank of England chief economist and MPC member Charlie Bean expressed apprehensiveness of the slowdown in the UK housing sector and hinted that one more rate cut would be the preferred course. Later, the market was surprised that at the December MPC meeting when status quo was maintained, there was one dissenting vote which was from someone other than Charlie Bean. These 2 factors together with upbeat US housing starts data and reinforced expectations of further Fed rate hikes had already pushed sterling down to the critical 1.73 support level. However, the 'last straw' on sterling's back appears to have been an unexpected drop in the UK Gfk consumer confidence index in December against a forecast improvement.

Sterling's sharp slide could well have been exaggerated by the thin, year-end market conditions. Still, a strong test of the 1.7050 could follow in the event of failure to regain the 1.73-plus level this week.

JPY

Fortnightly movement: O-115.55 H- 118.15 L-115.50 C-117.68
Sentiment: good (for yen) and may remain so
Expected range for 1 Month: 113.75-119.00
Expected range for 3 Months: 109.00-119.00

After the sharp, almost vertical drop in the week ending December 16, the dollar's recovery against the yen has been understandably feeble as compared to its recovery against the euro and sharp gains against sterling. Japan's core CPI rose 0.1% year-on-year in November, the first annual increase since October 2003 raising hopes that Japanese deflation may be coming to an end allowing Bank of Japan to exit its current ultra-loose monetary policy in early 2006. Japan's mrechandise trade surplus also rose for the 2nd consecutive month in November besides a smart 1.2% rise in the Tertiary Industry Index for October following a 0.8% fall in September.

Resumption of the dollar's uptrend seems unlikely before the recently seen bullishness has evaporated completely. USD/JPY declines are usually sharp and swift and quite often reach a near-panic stage. While 109 yen is a reasonable target over a 3-month time frame, don't be shocked if the dollar falls further. Only a sustained rise over 119 yen at this stage will probably point to a resumption of the dollar's uptrend.