The U.S. Federal Reserve Board's stand-pat statement on U.S. monetary policy Wednesday underlined the dominant theme for the sinking U.S. dollar: As long as the Fed is in no hurry to raise interest rates, traders will be in no hurry to buy the dollar.
With rates poised to head upward this year in most major economies outside the United States, other currencies will offer increasingly favourable returns for investors relative to the greenback, logic suggests. That implies that the downward pressure on the dollar will continue.
But is it possible that this latest bearish blow to dollar sentiment is actually sending out a screaming "buy" signal in disguise? Some market strategists think so. They say the mood toward the currency has become so dark that it's now overdone.
Baggy shorts and the PPP
David Watt, senior currency strategist at RBC Dominion Securities, noted that net short positions in U.S.-dollar futures have now exceeded 200,000 contracts for an unprecedented 11 straight weeks.
"The last time speculators were this negative on the dollar, in late 2007, the dollar was near a bottom," Brockhouse Cooper strategists Pierre Lapointe and Alex Bellefleur said in a research note this week.
"Currently, everyone is on the same side of the boat, and the least bit of USD [U.S. dollar]positive news could lead to a sharp reversal," they said. "The U.S. dollar is the opposite of an asset that is priced to perfection; it is priced to oblivion."
What's more, they added, the lengthy decline of the U.S. currency has left it "fundamentally undervalued" in terms of purchasing power parity - which compares the market value of currencies with the amount of goods they can actually buy. Based on this buying power, they said, the euro looks roughly 20 per cent overpriced relative to the greenback.
Relying on an outdated DXY
A key measure of the U.S. dollar's strength on a global basis, the U.S. Dollar Index ("the DXY," as it's known by its trading-screen-symbol nickname), may also be giving off a false sense that the greenback still has room to fall.
In a note to clients this week, Mr. Watt noted that the DXY - a trade-weighted index of the dollar versus six major world currencies - is skewed toward the euro, which accounts for nearly 58 per cent of the index. "That might have represented trade patterns in the early 1970s when the index was created, but [is]anachronistic and unrealistic now," he wrote.
By contrast, the Bank of England's U.S.-dollar effective exchange rate index - which is based on trade flows from the early 1990s - is more balanced, giving a 30-per-cent weighting to the euro, roughly the same as its weighting for the Japanese yen.
"The difference matters to an extent," he said. "The DXY index is still above the 2008 lows. The BoE USD measure has hit new all-time lows."
If you assume the BoE [Bank of England]measure is a better representation of the dollar's global value, this implies that the currency is already in uncharted depths.
Still an 'orderly' devaluation
But let's just say that the U.S. dollar, despite its overstretched state, is destined for further declines. Is the downfall a threat to financial market stability?
Not yet, said Stéfane Marion, chief economist and chief strategist at National Bank Financial. "The current depreciation of the USD remains orderly, as it has not been accompanied by a run on U.S. Treasuries," Mr. Marion argued in a research note this week.
This is different than in the U.S.-dollar depreciation of 1987, which, he said, turned "disorderly" when foreign investors unloaded U.S.-denominated paper, triggering a two-percentage-point surge in 10-year U.S. bond yields."This set the stage for the October, 1987, stock market crash," he said.
With the U.S. 10-year Treasury yield holding steady in the 3.5-per-cent area, despite the dollar's slide, no such crisis appears to be lurking now, he said.
David Parkinson