The Big Currency Question:
The Buck Stops Where?

By Jeremy Gaunt
European Investment Correspondent
LONDON (Reuters) -- Hedge funds may have triggered it, but the dollar's sharp slide over the past few weeks is more than just speculation -- it is a reflection of mainstream investors scrambling to dump the currency.
Whether the sell-off is warranted remains a matter of contention. But at least for now, momentum is propelling the dollar to record lows against the euro and unnerving some investors and companies who had bet differently.
"At the moment, the market has got the bit between its teeth," said Paul Duncombe, head of currency management at State Street Global Advisors. "(The dollar) can certainly go a lot further."
The dollar was testing $1.30 to the euro on Monday, having fallen in value from around $1.24 in mid-October when currency strategists said it broke definitively out of a 7-1/2 month trading range.
Given that a Reuters poll in mid-September showed leading investors expecting an end-year rate of around $1.20, the fall must have caught many by surprise.
Strategists said that the original mid-October break came courtesy of hedge funds who were testing the levels. After that, others -- medium-term investors, Middle East accounts and some corporates -- got into the act, buying euros before the price rose too high.
Increasingly, the pressure is also on those European companies which have not yet moved to protect their dollar-based earnings from the currency's downturn.
Thanos Papasavvas, currency strategist at Credit Suisse Asset Management, said his fund firm shorted the dollar when it broke out of the range at $1.2450 in mid-October.
"We hear that European corporates have not been doing that, so they have been caught on the wrong foot," he said.
THE BUCK STOPS WHERE? One gauge of how strong the current momentum is came on Friday after the U.S. Labor Department reported that non-farm payrolls rose twice as much as economists had expected.
Implying strength in the U.S. economy and further scope for interest rate increases from the U.S. Federal Reserve, the surprise data should have lifted the dollar. In the event, it did so only briefly before the decline resumed and the euro hit an all-time high.
"I think this is a pretty good guide (to) just how entrenched negative sentiment is toward the dollar," Richard Franulovich, senior currency strategist with Westpac Banking Corp, said at the time.
A second gauge came on Monday when European Central Bank President Jean-Claude Trichet said that recent moves were "unwelcome" -- the kind of comment that in the past has bolstered the dollar. The dollar did firm, but only briefly and the move was muted.
So where does the dollar go from here?
As for much of the year, the answer depends on what side of the great dollar divide you are on -- whether the large and growing U.S. current account deficit spells continuing weakness, or whether the U.S. economic landscape means dollar strength.
Mark Farrington, head of currency at Principal Global Investors, belongs to the latter camp.
He said the dollar is driven primarily by interest rate expectations and Friday's jobs data gave scope for the Fed to tighten more than earlier softness had implied -- a factor that will eventually lift the dollar.
"We are nowhere near the end with the Fed," he said, describing the current dollar sell-off as "a classic deviation from fundamentals driven by emotions."
Ranged against that view are those who see little to stop the dollar from falling to offset the current account deficit.
The re-elected administration of President Bush, it is argued on the one hand, will allow the dollar to decline, boosting U.S. exporters.
"Bush's non-interventionist or laissez-faire ethos means there will be no standing in the way of a dollar in need of further depreciation against all currencies," Mike Lenhoff, chief strategist at wealth manager Brewin Dophin Securities, wrote last week.
Trichet's ECB, meanwhile, is seen as benefiting from a higher euro as it eases inflationary pressures, particularly energy prices.
Its biggest fear is that the dollar decline will be faster than it has been to date.
Sentiment -- as judged by market moves -- clearly appears to be leaning heavily to the weak dollar side at the moment.
It could be driven even further if Europe's corporates truly have not hedged enough and are still long on dollars.
Credit Suisse's Papasavvas said both corporates and investment houses would take any slight strengthening of the dollar as an opportunity to sell. "We would expect some correction to take place, but not by more than a point or two, before fresh selling comes back in," he said.
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