Inflation fears weren't the original source of the U.S. dollar's slide, but they have taken over as the driving force of the greenback's downfall. No less an authority than the U.S. bond market is saying as much.
The bond and U.S. currency markets, which had followed divergent paths for much of the economic and credit crisis that began in earnest late last summer, converged in mid-April and have been moving in close sync ever since, with the dollar's slump against the euro mirroring the rapid rise of the U.S. 10-year bond yield.
Given that inflation expectations feed directly into bond yields, the parallel movements of the bond and currency markets strongly support the argument that inflation worries, fuelled by the Federal Reserve Board's aggressive monetary stimulus efforts, have taken over the U.S. dollar story.
A new risk in town
That's a substantial change from the early stages of the dollar's decline earlier in the year, which actually may have reflected much more optimistic sentiments, Bank of America-Merrill Lynch's global currency strategy team said in a report this week.
They noted that the dollar's initial declines, which came in conjunction with the start of the stock market rally, had the hallmarks of an unwinding of the massive defensive flight to the dollar that had driven it upward in the early part of the year, when investors turned to the greenback as a traditional safe-haven currency. An improved tone to the economy and credit markets eased risk perceptions, which contributed both to a return to the equity market and a reversal of those dollar gains.
But when the stock market rally levelled off through much of May, the dollar's decline didn't, as the new, darker catalyst took over, the analysts said.
"The reasons now appear to centre on growing inflation concerns, rather than growth expectations," they wrote.
The $1.44 wall
Nevertheless, B of A-Merrill thinks the U.S. dollar selloff may be near an end.
"We believe these [inflation]concerns are overdone," the currency strategists said. "While inflation expectations have risen, they have largely been bouncing off historic crisis lows, and are now back to where they were in the summer of 2008."
Based on long-term historical equilibrium valuations, they believe the U.S. dollar has moved into mildly undervalued territory, while the euro looks significantly overvalued.
Indeed, the greenback selloff hit a brick wall this week as the currency's chief foil, the euro, approached $1.44 (U.S.) - a peak to which it had spiked in December. That formed a particularly conspicuous technical support level for the U.S. dollar.
National Bank Financial technical analyst Dennis Mark noted yesterday that the dollar has also found support around the 79-level in the U.S. dollar index, its December lows.
These support levels could well provide a solid floor for the U.S. dollar for some time. Forward curves in the futures market are pricing in flat levels for the greenback against the euro, and most other major currencies (including the Canadian dollar), through the end of 2010.
The B of A-Merrill strategists think the U.S. dollar will do even better than that: They forecast a $1.28 euro by June and $1.20 by the fall - based on their expectation that the inflation bet will unwind.
"We still expect [U.S. dollar]weakness to eventually reverse rather than go off on a more extended secular broad-based decline … based on our skepticism of the dismal inflation outlook that the markets expect."