Dollar Fear Trumps Greed in Guarding Against Rebound

By Liz Capo McCormick

Dec. 7 (Bloomberg) -- Traders in the $3.2-trillion-a-day foreign-exchange market are paying the highest prices in more than a year to protect against a sudden rebound in the dollar after its worst annual performance since 2003.

That possibility may be less remote, according to Bill Gross, manager of the world’s biggest bond fund, who says a prolonged period of record-low interest rates may foster the “systemic risk” of new asset bubbles. Dubai’s effort to delay debt repayments reminded traders how the U.S. Dollar Index surged 16 percent in the two months after the September 2008 collapse of Lehman Brothers Holdings Inc. when investors sought a haven from the turmoil and poured money into U.S. assets.

“American investors have a lot of exposure now to foreign markets,” said Mansoor Mohi-uddin, the chief currency strategist at Zurich-based UBS AG, the largest foreign-exchange trader behind Deutsche Bank AG as measured by Euromoney Institutional Investor Plc. “If investors become risk-averse again, which happened last year due to Lehman’s bankruptcy and could happen now for a whole host of reasons, they are likely to go into less risky assets like U.S. Treasuries, which would help the dollar.”

While Intercontinental Exchange Inc.’s Dollar Index fell to a 16-month low last month, implied volatility on three-month call options granting the right to buy the greenback versus the euro exceeded that for options to sell it by 1.61 percentage points. The Dollar Index tracks the currency against the euro, yen, U.K. pound, Canadian dollar, Swiss franc and Swedish krona.

Risk-Reversal Rates

The so-called 25-delta risk-reversal rate, which was flat as recently as October, hasn’t shown such high relative demand for dollar calls since hitting a record 2.595 percentage points in November 2008. When the implied volatility of dollar calls exceeds puts, like now, the gap is expressed as a negative number, which would be minus 2.595 percentage points.

Investors are waiting for “the BOB event, a bolt out of the blue,” said John Alkire, the chief investment officer at Morgan Stanley Asset & Investment Trust Management in Tokyo. “The world had a mini-BOB,” when financial markets tumbled after Dubai announced plans to restructure some of its $59 billion in debt, said Alkire, who helps oversee $40 billion.

The Dollar Index had its biggest two-day gain in a month on Nov. 26-27, rising 1 percent, as Dubai’s proposal to delay debt payments shook investor confidence by risking the biggest sovereign default since Argentina’s in 2001.

It surged 1.7 percent on Dec. 4, the most since Jan. 20, after the Labor Department said employers cut the fewest jobs in November since the recession began. The Dollar Index traded at 75.566 as of 6:08 a.m. in London from 75.911 in New York late last week.

Double-Dip

Besides the financial turmoil in the United Arab Emirates, investors are also wary of the global economy falling back into recession with U.S. unemployment above 10 percent for the first time since 1983, non-performing U.S. commercial mortgage loans as measured by Moody’s Investors Service rising to 8.3 percent and the potential for stocks to fall after the steepest rally in the Standard & Poor’s 500 Index since the 1930s.

International Monetary Fund Managing Director Dominique Strauss-Kahn said on Nov. 23 that about half of bank losses from the global financial crisis have yet to be reported. The IMF said in September that banks, which have taken $1.72 trillion in losses and writedowns as measured by Bloomberg since the start of 2007, may have $1.5 trillion in toxic debt on their books.

“When viewed from 30,000 feet, there is even a systemic risk that new asset bubbles are in the formative stage,” Gross, the co-chief investment officer of Pacific Investment Management Co., wrote in his December investment outlook posted on the Newport Beach, California-based company’s Web site Nov. 19.

High Stakes

It’s not only currency traders that are concerned about a reversal in markets.

Forecasts for the fastest U.S. earnings growth in 15 years are failing to convince equity traders that the S&P 500 will extend its rally. S&P 500 options to protect against declines in stocks over the next year cost 40 percent more than one-month contracts, the biggest premium since 1999, data compiled by Barclays Plc and Bloomberg show.

Record-low interest rates in the U.S. have encouraged investors to borrow in U.S. dollars and reinvest the proceeds in countries with higher ones, such as Australia and New Zealand. The so-called carry trades, which contribute to weakness in the dollar, produced returns of about 50 percent over the past nine months, Bloomberg data show.

U.S. mutual fund investors raised the percentage of foreign assets in their holdings to 25.9 percent in October, matching the peak reached in mid-2008, based on Investment Company Institute data tracked by UBS. During the financial crisis, the percentage fell to 23 percent, after more than doubling from 2002.

Rising Volatility

The dollar has depreciated 6.2 percent against the euro this year, 23 percent versus Australia’s currency and 19 percent versus the New Zealand dollar.

Investors are buying options to protect their positions “given that recent moves in the exchange rate have been nasty on the downside,” said Neil Jones, head of European hedge-fund sales in London at Mizuho Corporate Bank Ltd. “Investors bullish on the euro are prepared to pay a premium for the automatic stop-loss the options provide while also keeping their cash position in play.”

JPMorgan Chase & Co.’s G7 Volatility Index rose to 14.43 last month from the low this year of 12.32 in September. The 10- year average before the 2008 credit crunch was 9.9 percent.

Strategists are cutting their forecasts for the greenback. The dollar will depreciate to $1.55 against the euro by March from $1.49 last week, and to $1.62 by June, according to JPMorgan. Since September, the median June 2010 estimate for Australia’s dollar has risen to 94 U.S. cents from 85, and jumped to 74 U.S. cents from 67 for New Zealand’s currency.

No Policy Changes

Any flight to the dollar may prove short-lived, with the Federal Reserve signaling it will keep rates at a range of zero to 0.25 percent for an extended period, according to Axel Merk, president of Palo Alto, California-based Merk Investments LLC.

“If Dubai signals one thing, it’s that the odds of the central bank policy makers around the world mopping up all the liquidity they’ve provided anytime soon may be rather low,” said Merk, who manages more than $550 million in mutual funds that specialize in currencies.

Dollar bears also say the U.S. government shows little concern about the currency’s decline, paving the way for further depreciation. That’s because a weaker greenback has helped to bolster exporter earnings. U.S. exports increased for the last five months, the Commerce Department said Nov. 13.

Undue Speculation

The depreciating dollar is proving no deterrent to demand for U.S. financial assets. For every $1 of debt sold by the Treasury this year, investors put in bids for $2.59, up from $2.19 at this point in 2008.

Traders pushed up the cost to protect against a rise in the dollar after Fed policy makers said last month that their decision to cut rates to zero may be fueling undue financial- market speculation.

Its policy of keeping rates low might cause “excessive risk-taking” or an “unanchoring of inflation expectations,” according to minutes of the Nov. 3-4 Federal Open Market Committee meeting. The committee members also said the dollar’s decline has been “orderly.”

Nouriel Roubini, the New York University professor who predicted the financial crisis, said last week that Dubai’s attempt to reschedule debt underscores the global economy’s vulnerability to a setback.

‘Vulnerabilities’ Remain

“Although Dubai World’s financing issues are not a surprise and are relatively small given global credit losses, they are a reminder that the vulnerabilities and imbalances that contributed to the credit crunch have not disappeared,” Roubini said on his RGE Web site on Dec. 2.

The three-month risk reversal rate for options on the Australia-U.S. dollar exchange rate reached minus 3.57 percent on Nov. 27, the most since February. On the same day the New Zealand-U.S. dollar exchange rate, it hit minus 3.92 percent, the biggest negative since February.

“People saved money in the past by not insuring themselves, which proved to not be a great trade,” said Nick Parsons, head of markets strategy in London at NabCapital, a unit of National Australia Bank Ltd., the country’s largest bank by assets. “There is plenty of incentive and opportunity to hedge now. People are much more willing to buy insurance.”

To contact the reporter on this story: Liz Capo McCormick in New York at emccormick7@bloomberg.net.