http://www.ft.com/cms/s/0/cb35c716-1861-11dd-8c92-0000779fd2ac.html

Tide begins to turn for dollar

The dollar, so long the whipping boy of the foreign exchange markets, has started to fight back.

Pushed to a record low against the euro only last week, the US currency has recovered sharply, triggering speculation that its seven-year downtrend might be coming to an end.

This week’s signal from the Federal Reserve that it had paused in its interest rate-cutting cycle was the driving force behind the dollar’s renaissance.

But analysts say rising US equity markets and improving US economic data also gave the dollar a lift.

“This combination has been unambiguously positive for the dollar, but for now we are just enjoying the moment and pushing it higher,” says Michael Woolfolk at Bank of New York Mellon.

“But if we get confirmation that these three factors are the start of a trend, then the dollar has put in a bottom here.”

The dollar suffered as the Federal Reserve embarked on its aggressive interest rate-cutting policy last summer, slashing its main rate by 3.25 percentage points to 2 per cent.

This attempt by the US authorities to bolster growth in the face of the credit crisis sent the dollar down to a series of record lows against a raft of currencies.

However, as the fallout from the subprime crisis spilled out across the world, domestic economic data in other countries began to deteriorate.

The UK and Canada were the first to feel the effects, pushing the Bank of England and the Bank of Canada into their own rate-cutting campaigns.

This prompted a rebound in the dollar from a 26-year low against the pound and a record trough against the Canadian dollar.

Now, just as the Fed has signalled it may pause its interest rate-cutting cycle, there are signs that economic conditions in the eurozone are starting to crumble. This could eventually prompt the European Central Bank to abandon its hawkish stance and start cutting interest rates.

This, analysts say, could trigger a rebound in the dollar against the euro. The greenback has hit a series of record lows this year and dropped more than 60 per cent against the single currency since 2001.

Hans Redeker at BNP Paribas says weak eurozone retail sales and activity data imply domestic demand in the eurozone has weakened while export growth is easing.

“Exports cannot now act as the one and only pillar of eurozone economic growth support as demand slows down globally,” he says. “Within this context, the euro looks drastically overvalued.”

Marc Chandler at Brown Brothers Harriman says he has long argued that the dollar has already bottomed against the pound and the Canadian dollar and has been carving out a bottom against the euro.

He says the pieces of the puzzle that need to fall into place for a dollar upturn against the euro include a narrowing of growth differentials in favour of the dollar and a shift in monetary policies in favour of the dollar.

“The monetary policy shift appears to be beginning and that has already provided dollar support,” says Mr Chandler. “The Fed’s ability to remain on hold in coming months will depend on whether the US economy begins to gain some traction in the second half of the year.”

Other factors are also supporting the dollar.

A growing feeling that the worst of the credit crisis might be over has fuelled risk appetite, drastically reducing demand for the haven of the low-yielding yen.

Indeed, the yen has fallen sharply in recent weeks, dropping more than 7 per cent from the 13-year high it hit against the dollar in March.

Mr Woolfolk says markets tend to turn a blind eye to unfavourable news if they feel the worst-case scenario has already been accounted for. “Recent signs of immunity to unfavourable banking-related news suggest this point has been reached,” he says.

Meanwhile, China’s decision to let the renminbi strengthen faster has also supported the dollar. Although this reduces the country’s accumulation of dollar reserves, it also reduces the need for China to diversify its holdings away from the dollar in order to balance the proportion of currencies within its holdings.

The diversification of global central banks’ $6,000bn of reserves away from the dollar has been a drag on the currency in recent years.

However, Mansoor Mohi-uddin at UBS says it is the activity of American asset managers, who have $27,000bn under their control, that matter most for the currency markets.

He says signs that US investors have stopped diversifying away from the dollar could support the currency further.

From 2003 to 2007, US mutual funds increased the proportion of foreign assets in their portfolios from under 15 per cent to 25 per cent. However, since the credit crisis intensified in October, the rising share of foreign assets has come to a halt.

“With the US equity market outperforming European markets this year for the first time in six years, Americans’ dollar diversification may be peaking,” he says.

Did the Kwa pull a magic rabbit out of their asses again or is this just a blimp up on the way down?