Dollar Gain Signals Pain as Rally Prompts Exit From Bull Trade

By Ye Xie and Anchalee Worrachate

Aug. 11 (Bloomberg) -- Just because the dollar posted its biggest gain against the Euro in almost eight years doesn't mean the U.S. currency won't continue to be plagued by the nation's slowing economy, widening budget and trade deficits and negative inflation-adjusted interest rates.

The 4 percent surge against the single European currency this month was enough to prompt Bank of America Corp. to tell its customers to exit trades betting on more gains. Morgan Stanley still forecasts the greenback will approach a record low by October as the U.S. housing slump and credit-market losses keep the Federal Reserve from raising interest rates this year.

Barclays Plc in London and New York-based Merrill Lynch & Co. said trading patterns suggest the dollar's 5.1 percent gain in the past three weeks measured by an index of six major trading partners can't be sustained.

That's mostly because there's no indication the U.S. will return to the late 1990s annualized gross domestic product growth of 4.23 percent with inflation running at no more than 3.3 percent. Since September, 2000, the dollar has declined more than 44 percent as inflation accelerated to an annual 5 percent today, growth slowed to 1.9 percent and U.S. interest rates provide no cushion for holding U.S. assets.

``I would not chase the dollar's strength versus the euro as the pair has moved beyond interest-rate support,'' said Sophia Drossos, a strategist in New York at Morgan Stanley, who also recommended closing out bets on the dollar versus the currencies of Malaysia and Singapore. ``The dollar is not out of the woods. It will take the market a while to come around to our point of view.''

Unsustainable Recovery

The dollar strengthened to $1.5005 to the euro last week from $1.5564 on Aug. 1, the biggest weekly increase on a percentage basis since January 2005. It surged 2.08 percent on Aug. 8, touching $1.4998, the most since Sept. 6, 2000, and the second largest rally since the euro was introduced in 1999.

Those gains sent the dollar above the $1.51 per euro yearend mean target of 39 analysts in a survey by Bloomberg. By the end of 2009, the dollar will likely strengthen to $1.40 per euro, based on the estimates. It gained 6.4 percent since hitting a record low of $1.6038 on July 15.

In addition to the gains against the euro, the dollar also appreciated 2.3 percent versus the yen to 110.18, the most in eight weeks. The euro lost 1.29 percent against the Japanese currency to 165.38, the biggest drop in 13 weeks.

U.S. economic data suggest that a sustained recovery isn't imminent, said Robert Sinche, head of global currency strategy at Bank of America in New York. Interest-rate swaps indicate the currency should trade at about $1.54 per euro, said Sinche, who still forecasts that the dollar will strengthen to $1.45 per euro by the second half of next year.

Foreclosures, Deficits

The number of U.S. home foreclosure filings more than doubled in the second quarter from a year earlier, according to RealtyTrac Inc., a seller of default data. Government reports this week may show retail sales fell 0.1 percent in July, the first decrease since February, and the U.S. trade deficit widened in June to $62 billion from $59.8 billion.

The U.S. budget deficit, which totaled $163 billion for 2007, is forecast by the administration of President George W. Bush to widen to a record $482 billion for 2009.

Morgan Stanley predicts the dollar will weaken to $1.60 by October, because the faltering U.S. economy means the Fed is unlikely to raise rates anytime soon, Drossos said. That means investors will continue to suffer inflation-adjusted returns that are negative based on the current annual consumer price index of 5 percent and Treasury securities yielding between 1.695 percent for three-month bills and 4.53 percent for 30-year bonds.

`Particularly Weak'

Rather then a vote of confidence in the outlook for the U.S. economy, the euro's tumble on Aug. 8 was triggered by traders paring bets the European Central Bank will lift borrowing costs after ECB President Jean-Claude Trichet said economic growth will be ``particularly weak'' through the third quarter. Trichet spoke after the central bank left the main refinancing rate at 4.25 percent.

Gross domestic product growth in the euro region is expected to slow to 1.7 percent this year and 1.3 percent in 2009, from 2.68 percent in 2007, according the median forecast in a Bloomberg survey. U.S. GDP will slow to 1.5 percent before rebounding to 1.8 percent next year, another survey showed.

``The outlook is looking certainly brighter for the dollar,'' said Nick Bennenbroek, head of currency strategy in New York at Wells Fargo & Co. ``The most significant factor is that there are now much clearer signs that U.S. economic weakness has spread to global economic weakness.''

`Overshoot Territory'

Wells Fargo forecasts the dollar strengthening to 1.48 per euro by the end of next year.

David Woo, head of currency strategy in London at Barclays, disagrees. ``The euro-dollar market is in an overshoot territory,'' he said. Barclays, the world's third largest currency trader, according to an annual survey by Euromoney magazine, expects the dollar to weaken to $1.57 per euro by year-end.

Dollar bears point to the Fed's decision on Aug. 5 to leave its target rate for overnight loans between banks at 2 percent for a second straight policy meeting. Policy makers said ``downside risks'' to growth remain, while inflation is a ``significant concern.''

Futures on the Chicago Board of Trade show a 40 percent chance the Fed will raise its target rate at least a quarter- percentage point by year-end and a 90 percent probability of higher borrowing costs by the end of March.

`Balance of Risks'

``We still see the balance of risks to the upside for euro- dollar given considerable headwinds facing the dollar and unrealistic pricing for Fed hikes,'' strategists led by Ray Farris at Credit Suisse Group in London wrote in a research note at the end of last week. The dollar may decline to $1.61 per euro by the end of next month and to $1.64 by year-end, they said, the most bearish forecast in the Bloomberg survey.

Traders who look at charts of price patterns say technical indicators suggest the dollar's rally may have been exaggerated.

Losses accelerated Aug. 8 when the euro dropped below $1.53 and broke the 200-day moving average for the first time since April 2006. Currencies typically revert toward their mean price after breaking through averages unless new ranges are established.

Trading envelopes, which measure how far from the mean a price has strayed, show the euro's decline is double the typical changes versus the dollar in the past 20 days, suggesting that the dollar is either establishing a new level or will trade closer to the average price.

`Bit Too Fast'

The 14-day relative strength index fell to 22.31, the lowest since the euro's debut. A relative strength index level below 30 suggests a currency's decline is extreme and a reversal may be imminent.

``We are looking for the euro-dollar to move down over the year, but feel that the current move is a bit too fast,'' said Emma Lawson, a currency strategist in London at Merrill Lynch, which still expects the dollar to rise to $1.48 per euro by January. ``The dollar has started from a position of being undervalued while a lot of these currencies are overvalued.''

To contact the reporters on this story: Ye Xie in New York at Yxie6@bloomberg.net; Anchalee Worrachate in London at aworrachate@bloomberg.net.