By Steven C. Johnson and Steven Vames
Of DOW JONES NEWSWIRES
Monday July 26
NEW YORK (Dow Jones)--Having already rallied sharply against its major European rivals, the dollar faces a critical test this week, as it looks for strong growth and inflation data to break key technical barriers and extend those gains.
After a long bout of sluggishness, the dollar finally broke higher last week, with Federal Chairman Alan Greenspan's upbeat assessment of the U.S. economy during testimony before Congress kicking off the rally.
Greenspan's assertion that the U.S. recovery has become self-sustaining and his hints that the Fed will lift interest rates at a gradual pace while remaining on alert for inflation forced investors to cover short dollar positions and sent the euro tumbling below $1.21 for the first time in nearly a month.
Late Friday, the single currency was at $1.2096, more than a cent off $1.2251 late Thursday. Sterling slipped to $1.8307 from $1.8430. The dollar also surged against the Swiss franc, trading around CHF12672 Friday, a one-month high, compared with CHF1.2486. Against the yen, the dollar was at Y110.04, above Y109.74.
Dealers said the market hasn't been so short dollars since February, when the euro hit its yearly high around $1.29. Indeed, that partly explains why the dollar fared so well last week. With the market positioning so extreme, the dollar's rally caught many in the currency markets off guard and potentially paves the way for further gains this week.
"It's astounding when you stop to think about it. Even in the face of the pressure the stock market's been under in lately, the dollar has rallied very significantly," said John McCarthy, foreign exchange director at ING Capital Markets in New York.
Key euro support this week lies around $1.2060-70, he said.
Against a backdrop of rising expectations of a strong second-quarter U.S. gross domestic product report on Friday, many market participants are betting that the dollar will be able to sustain its recent momentum.
Economists are anticipating a 3.6% increase, after a 3.9% jump in the first three months of the year. Greenspan last week said the Fed sees GDP growing 4.5%-4.75% in 2004.
"We just got through a spate of weaker-than-expected U.S. data over the last four to six weeks, and I think that phase is drawing to a close," said Ram Bhagavatula, chief economist for North America at the Royal Bank of Scotland in New York, adding that markets are also anticipating healthy July durable goods data this week.
Ashraf Laidi, chief currency analyst at MG Financial in New York, said the dollar's run against the euro have given it a "psychological edge" that could keep it on the offensive.
In addition to GDP, he said data on consumer confidence, due Tuesday, and Thursday's employment cost index, a quarterly indicator that measures growth in wages and benefits and is seen as a key inflation gauge - will be closely watched as well.
"People want to see whether Greenspan's positive forecast will be reflected in the data, and this is data on inflation and growth - the two things that underpinned Greenspan's speech," he said.
Currency analysts at BNP Paribas also said strong data should boost U.S. interest rate expectations, adding that the steepening Treasury curve and carry-trade unwinds in commodity currencies will also support the dollar.
The bank predicted that sterling may remain particularly vulnerable against the dollar as U.K. housing markets and corporate profitability slow.
Still, doubts remain about whether the dollar's newfound strength is more than skin deep.
"The foreign exchange market reaction (to Greenspan's testimony) was far more dramatic than that of other asset markets," Steven Englander, noted chief currency strategist at Barclay's Capital in New York. "This suggests we observed another adjustment of positions rather than a fundamental revision of views."
Some market participants have said that after failing earlier in July to break above $1.2460 en route to $1.25, the euro may now be set to probe around the $1.18-19 level, the low end of the broad range that has prevailed over the past several months.
But until the more weighty data toward the end of the week comes in, directional trends may remain short-term and choppy, and therefore, risky for most investors.
To avoid the market's whimsical ebbs and flows, a growing number of investors are making the best of the situation by seeking out foreign exchange options rather direct positions in currencies.
Options give investors the ability to cast bets on volatility, or the intensity of fluctuations in the market, without the broad risk of holding long or short currency positions. Using options, investors can make bets that the market will move a certain increment higher or lower, or simply that the market will move.
For investors - soured on a stock market that is flirting with its lows of the year, a bond market in constant threat of interest rate hikes, and a stalled commodities market - buying options represents a low risk, worthwhile reward.
"This is the year to buy options," said Laurie Cameron, head of global foreign exchange at J.P. Morgan Private Bank. "The markets have been so terribly dull, so volatility has really become one of the only games in town. At any other time we're net sellers of options but right now we're net buyers."
Now that the dollar has rallied back following a two-week selloff, dollar calls - options that give buyers the right to buy dollars at an agreed price at a future date - have come back into vogue. The calls reflect a belief that the dollar's rivals, after failing to push through key resistance last week, are now headed lower against the U.S. currency.
For buyers of dollar calls, the hope is that the dollar rally will build additional momentum if it forces a growing number of investors to abandon dollar-bearish trades.
"We haven't seen the long-term position players get involved in this rally yet," said Scott Ainsbury, portfolio manager at FX Concepts, a New York investment management firm, referring to investors who take a longer-term view of the market. If do join, the dollar could have further to go, he said.
More Financial News