Articles

The Dollar Dilemma
By Marc Chandler and Jeffrey McCarthy

Related ETFs: FXY / EWJ

Page 1 of 5

The dollar’s swoon against a broad swath of currencies since the end of first quarter 2009 raises a few questions for investors: Is it an opportune time to invest in the dollar? Has the greenback hit bottom?

These are questions that many financial advisers and individual investors can legitimately ask themselves for the first time, as innovations in exchange-traded products have presented opportunities for single-currency hedging in ways never seen before.

Below, we offer three factors that these investors can use to help identify a dollar bottom, or its reverse.*

Interest-Rate Differentials

One key factor investors should consider is the relative interest rates in competing markets. For most investors, the key comparison will be made to the euro, the other dominant currency on the international market. German bunds are used as the proxy for the eurozone, since Germany is Europe’s largest economy and the European Economic and Monetary Union does not itself issue bonds.

As of late August, for instance, the story was mixed. Although U.S. five- and 10-year bond yields are above those for German bunds, short-term rates—which appear to be more important in the foreign exchange market—are below similar German rates. Those interest-rate differentials mean that it still pays to short dollars.

This has to and will change, but it will take some more time. As of late August, the U.S. two-year yield is about 20 basis points below the German two-year yield, but the spread has narrowed by about 10 basis points over the past month. Given the strong likelihood of a relatively robust third-quarter GDP in the U.S. (the consensus is rising from 0.8 percent; Greenspan talked about the possibility of 2.5 percent; a couple of former investment banks are on the record calling for 3 percent), the U.S. two-year yield may rise above Germany’s by early in the fourth quarter. This could help mark a bottom for the greenback.

We can use the eurodollar and Euribor futures to review short-term rates expectations for the future. As August drew to a close, the December 2010 contracts’ three-month eurodollar yields were about 10 basis points (bps) below similar Euribor yields. The June 2010 contracts show three-month eurodollar yields almost 25 basis points below Euribor yields. The December 2009 three-month Eurodollar yield is about 38 basis points lower than Euribor. Short-dated forwards, which account for the bulk of foreign exchange positions, are priced off of short-term interest-rate differentials.

The dollar’s relationship to interest-rate differentials is not linear, but rather cyclical. In the beginning of an idealized business cycle, U.S. rates are low and the dollar is weak. Based on analysis of past experience with past downturns, it appears that as the recovery gains momentum, short-term U.S. interest rates may rise, but the dollar is likely to remain soft. Over time, as U.S. interest rates rise, it changes the incentive structure, and the dollar begins getting better traction. With such interest rate compensation for the currency risk no longer needed, after a period of time, U.S. rates should begin easing relative to other countries, but the dollar is predicted to stay firm. It remains this way for a period of time before the narrowing of interest-rate differentials begins undermining the greenback once again.

At this point in the dollar’s cycle, widening interest-rate differentials are a precondition for a sustained advance. But to be clear, U.S. short-term interest rates rising above those in the eurozone will not necessarily signal an immediate commencement of a dollar rally: There is often a lag.