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This is when dollar bulls need nerves of steel. But they will probably find that holding their nerve pays off.
For the past few days, the U.S. currency has come under attack as fears over a U.S. debt default have risen and a helpful slide in commodity prices has come to an end.
Investors appeared quick to take profits on the rally that had been driving the dollar higher since the start of the month.
However, that rally should soon resume.
For a start, negotiations over a higher U.S. debt ceiling were always going to be protracted and the chances of a government shutdown taking place after the Aug. 2 deadline have always been high. It is how the U.S. Congress does business: take it down to the line.
If anything, the rise in the price of U.S. credit default swaps this week will help to act as a wake-up call to politicians as they seek a way to keep the U.S. government from going insolvent.
Next, the rebound in commodity prices.
With the U.S. itself still showing a very fragile economic recovery; with growth in China slowing down faster than before and with Japan now in a deeper post-earthquake contraction than expected, global demand for commodities is still expected to fall.
The decline in prices is just not going to happen in a straight line, especially with oil markets likely to take fright at the prospect of Iranian President Mahmoud Ahmadinejad planning to chair meetings of the Organization for Petroleum Exporting Countries while Iran holds the presidency.
In the meantime, confirmation from the latest FOMC minutes that the Fed is talking about raising rates again after QE2 ends and a bounce in U.S. Treasury yields from a five-month low both suggest that the U.S. currency could start to find rate expectations working in its favor.
The argument that central bank diversification"”swapping their dollar-denominated reserves for other currencies such as the euro"”will continue to weaken the U.S. currency is also starting to lose its merit.
Not only has the whole diversification process been reduced, as the need for market intervention by China and many other Asian countries has declined in the past few months, but central banks may be more reluctant to risk sending the dollar down too low.
Geoffrey Yu, a senior currency strategist with UBS, summed up the dilemma they face in a recent paper on diversification: “Sovereign-wealth managers understand that they have far more to lose if divestment of U.S. paper results in a dollar crisis, as the purchasing power of their national assets will decline.”
The fact that speculators have pushed their short dollar positions to extreme levels in the region of $50 billion in recent weeks could also work in the U.S. currency’s favor.
According to Michael Derks, chief strategist at FxPro, “in the past when short positions have become this extreme it has coincided not long after with a significant short-coming rally.”
In the meantime, dollar bulls who have doubts only have to look around to see that alternatives to the U.S. currency are hardly plenty on the ground.
The woes of the Japanese economy are fairly obvious and as the Bank of England minutes made clear this week, the U.K. is burdened with high inflation and a recovery that is proving weaker than anticipated.
The euro zone is also hardly the attractive destination it once appeared to be. The debt problems of Greece continue to loom with the European Central Bank and euro-zone politicians now at loggerheads over how to proceed.
Growth in Germany and France may be steaming ahead but they are leaving behind their poorer neighbors and putting the future of the euro and the ECB’s one-for-all monetary policy even more in doubt.
So while the dollar’s slide may be testing their nerves right now, dollar bulls will find it best to hang on.
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The Source is WSJ.com Europe’s home for rapid-fire analysis of the day’s big business and finance stories. It is edited by Lauren Mills, based in London.
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