Decline ahead for greenback as bulls turn into bears
There is an old rule of thumb in the financial markets that goes something like this: when everyone is convinced a market is going to rise, then it is about to fall.
This is more than a simple rehash of Murphy's Law. The reasoning is that if all investors are bullish, that means everyone who is likely to buy has already done so and with no more potential buyers left to bid prices up, the market has only one way to go - down.
The maxim works equally well in reverse. When everyone is in bearish mood, it means the market has hit bottom and is about to rise again.
We saw this at work at the beginning of this year. Almost without exception, economists, market strategists and investors all thought the US dollar was going to fall this year. As evidence, they pointed to the monstrous size of America's current-account deficit - its overdraft with the rest of the world - which last year grew to almost 6 per cent of gross domestic product.
The only way for this unprecedented imbalance in the global economy to correct would be for the dollar to weaken, said the bears, and almost everyone bought their argument.
Er, whoops. Instead of falling, the dollar rose strongly over the first half of this year. On a trade-weighted basis, it appreciated 8 per cent since the beginning of January.
Most people's attention has been focused on the euro, against which the dollar has risen 13 per cent. But Asian currencies, which were universally deemed undervalued at the beginning of the year, have not fared much better. Undervalued they may have been, but the yen, baht, rupiah and the Singapore dollar have all slipped against the greenback.
Part of the reason for the US dollar's strong performance is the unexpectedly robust growth of the US economy. With first-quarter GDP growth now revised up to 3.8 per cent, the United States is expanding at three times the rate of Europe and almost five times that of Japan.
Higher short-term interest rates have also bolstered the dollar. With three-month US rates now at 3.5 per cent, and European and Japanese rates static at 2.1 and 0.1 per cent respectively, it makes far more sense to borrow yen or euros to buy dollars than the other way round.
Politics has played a role, too. Confidence in the euro was hurt by the French and Dutch rejection of the proposed European constitution. Meanwhile, in Asia, central banks have continued to buy dollars to maintain their export competitiveness, especially since the trade cycle has begun to weaken.
But although the pundits miscalled the dollar over the first six months of the year, they may still have been right about its long-term trajectory. After all, the current-account deficit has not gone away and viewed over three years, the dollar's trend is still downwards.
According to analysts at Deutsche Bank, short-term reversals such as the current bear market rally are normal for the dollar. Historically, they tend to last a few months and back the currency up about 12 per cent against the prevailing trend.
In other words, now that the market has turned bullish on the dollar, the greenback could be set to begin weakening again in the second half of the year.
One catalyst could be a change of exchange-rate policy from China to allow the yuan to trade more flexibly in line with supply and demand.
That would refocus market attention on the perceived undervaluation of Asian currencies and possibly initiate a fresh round of dollar depreciation, this time against Asia.