What's Behind the Recent Dollar Strength

By Evaldo Albuquerque

The dollar has been rallying for the last few days. But can it last? Have we seen the bottom of the dollar decline? A look at the forces behind this recent dollar strength can give us some insight.

The rally started last Friday right after the much better than expected unemployment numbers. Traders started to speculate that the Fed would raise rates much sooner than expected. So that was very bullish news for the dollar.

But Bernanke put those speculations to rest yesterday, when he once again reaffirmed that rates will remains low for an extended period of time.

So after Bernanke’s speech, I was expecting the dollar downtrend to resume. But the dollar is still rallying. What is driving the dollar now is risk aversion, as opposed to expectations of higher rates. 

During Bernanke’s speech he emphasized that the economy is still weak, raising some concerns about the pace of recovery. The dollar rallied picked up speed this morning after credit-rating companies highlighted the risk of government deficits and German industrial production unexpectedly dropped.

A look at the Yen confirms that the dollar is now moving on back of risk aversion flows. As you know the Japanese Yen also tends to appreciate when uncertainty rises. On the chart below, you can see that after the unemployment report, the dollar rallied and the yen fell.

Movements in the Yen confirms that risk aversion is now driving the dollar

The dollar rallied because of expectation of higher rates, as I mentioned before. The Yen fell for the same reason. Higher rates in the U.S. would make the Japanese currency once again the preferred funding currency for carry trades. After all, one of the main reasons behind the recent strength of the Yen is the fact that rates are comparable between Japan and U.S.

After Bernanke’s speech, the Yen appreciated because the message from the Fed supported the dollar carry trade. The Yen has also been benefiting from risk aversion flows, which is now keeping the dollar from falling.

That raises a more important question: is this dollar rally for real? I’m not convinced yet. Since the dollar is being moved by sentiment, any flow of good news can trigger another leg down on the dollar.


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