Is the U.S. dollar’s rally since July topping out?

From its all-time low of 1.605 versus the euro the U.S. dollar has gained a cumulative 18%. The buck now ranks among the world’s strongest currencies since July, trailing behind the Japanese yen. The dollar has soared versus all majors units since July causing all sorts of losses for hedge funds, companies and individual investors. It’s been a disaster.

But let’s not confuse dollar strength with a bull market for the greenback. The dollar has enjoyed a short-term accounting anomaly since July in the face of a global credit squeeze and a mad-dash for dollar liquidity. It has absolutely nothing to do with improving economic fundamentals. This is a dollar liquidity story and not the start of a secular bull market like we last saw in 1995.

Just a few months ago the dollar was on everyone’s short list, including hedge funds and individual investors. As the dollar has recovered spectacularly since July a whole series of leveraged bets on currencies, commodities, stocks and leveraged loans have all come home to roost. This unwinding of the carry-trade has also enormously benefited the yen.

The dollar is now coming under pressure again. For the first time in 100 days the dollar is showing signs of fatigue following the Fed’s interest rate cut on Wednesday. Other economies are also slowing rapidly this fall and a host of central banks are now cutting rates, too, including the Chinese, Norwegians, Australians, Canadians, the ECB – you name it. The name of the game now is global reflation.

The market has been incorrect awarding a dollar premium since July. The consensus is that the United States is doing everything it can to fix its economy while other countries, namely in Europe, remain far behind the U.S. recovery curve. This, in part, is true. Economic problems in Europe are worse in many ways with severe turbulence now brewing in its Eastern European backyard as the IMF, EU and World Bank come to the assistance of Hungary and others.
The Europeans are right in the middle of accelerated deflation as credit markets are busted, liquidity at banks has collapsed and currencies in the region tank.

The dollar is not a safe haven in this crisis. It’s a “liquidity” haven. If the dollar was truly King of the Hill it should be strengthening, not weakening, against the yen.

I suspect the dollar’s rally is not over. I’m still expecting the market to eventually test its October 2002 lows and that event will likely be dollar bullish. But a short-term correction seems likely at this point and is consistent with a big global stock market rally and a compression of credit spreads over the last 10 days. More risk is entering the market and that’s bad news for the dollar and the yen.

Again, if we’re expecting markets to test the October 2002 lows, then the dollar’s short-term decline is only temporary; the bulk of the credit bear market is over at this point but the real economy now faces serious challenges to consumption.

The Fed cut rates to 1% yesterday. Before it’s all over I expect the Federal Funds rate to be 0%. We’re heading exactly down the same road as the Japanese almost 20 years ago. The only difference is that this hard recession won’t last 10 years like it did in Japan because U.S. authorities aren’t vacillating like the Japanese did. But the resultant cost of this extraordinary spending blitz will be enormous and exacting on U.S. finances and ultimately, the dollar.