The spring stockmarket rally has seen the Dollar slaughtered as traders switched into higher-risk currencies. But is that trade looking a bit tired now and should we be preparing for a change of direction?

The Dollar has lost nearly 3000 pips against Sterling since March, 1500 against the Euro. But that’s about half-way towards reversing the previous slide associated with the credit crunch. The question is whether there’s enough steam to continue the trade or whether this move, like the equity rally, has merely been a reaction to less bad data.

Long Term Influences
I could write a cure for insomniacs about the future risks of holding Dollars but as traders I don’t think it’s relevant. So, I’ll list a few just to tick the box and then concentrate on what matters now:

1. The obvious one; the Himalayan mountain of debt will leave the US rattling the overseas collection tin for years to come, but the same could be said of the UK.
2. Related to this is the risk of a credit rating downgrade, not now, perhaps never, but the worries will keep cropping up. Again, this is perhaps more of a concern for the UK.
3. An alternative reserve currency. Again, this isn’t a serious risk for now, but there’re a lot of side issues that will spook the market from time to time (see below).

What’s Happening Now?
These are the issues we need to focus on as traders:

Risk Appetite
Let’s start with an obvious one. My take on recent market moves is a simple one. Good demand for equities (and corporate bonds) has highlighted the appetite for risk; this has extended into the forex market with buying of higher-yielding currencies against the Dollar. The weaker Dollar has led to buying of gold.

So for several weeks the view has been if stockmarkets are still rising then sell the Dollar. If/when you think stockmarkets are going to fall then get ready to buy the Dollar.

Diversification
Yesterday Russia, and to a lesser extent Brazil, caused a minor tremor with the announcement that it would swap US bonds into IMF debt. This came hot on the heels of a similar statement of intent from China and raises a couple of interesting points:

1) The IMF doesn’t have any bonds at the moment; it’s planning to discuss the matter sometime in June/July. These bonds are likely to pay a similar yield to US bonds but be denominated in a basket of currencies called SDRs.

2) These countries claim their statements are intended to show support for the IMF and to make clear that they’re not looking for funding hand-outs. It doesn’t help them to weaken the Dollar (they hold too many) but it is sensible for them to diversify their risk.

3) The other interesting point was traders’ reaction to the news; the obvious move was to sell the Dollar (I joined in briefly) as previous similar announcements had resulted in major moves. But the sharp mark-up didn’t last for long and the price ended the day lower than before the announcement. To me this suggested that whilst traders might be happy to see a weaker Dollar they’re less keen on opening new positions at this level.

It’s worth being aware of the BRIC summit taking place on June 16th as there’ll be rumours, speculation and the odd utterance from leaders in the run-up to the summit.

Bond Yields
I believe this is the most interesting factor at the moment, and that it’s starting to have an influence over stockmarkets as well as currencies. We all know the US needs to employ Wal-Mart rather than Goldmans to sell the billions of treasury bonds-pile ‘em high and sell ‘em cheap. And that’s becoming a problem; check out this chart of 10-year bond yields:

When you compare the 2% yield at Christmas to the 4% yield now, think corporate financing, or mortgage applications. Yesterday the US government had to issue 10-year bonds at 4% to attract enough buyers. For comparison UK bonds yield 3.91% and Euro bonds a bit less at 3.70%.

Higher bond yields can be used to argue the merits for a weaker and stronger Dollar. The pro-Dollar argument is that investors are more likely to invest in the higher-yielding bonds and they’ll need to buy Dollars to do this.

The opposite view is that if investors are demanding 4% now and there are billions and billions of bonds that still need to be issued then the price will need to fall further so why rush in now?

At the moment I think the argument favours the Dollar; that bonds were oversold on wild speculation that the US would be likely to raise rates before the year end. I think before then we’ll see a slowdown in the economy and bonds will benefit as shares fall/ slide/collapse. Today will provide a further test when the government tries to sell $11 billion 30-year bonds, currently yielding 4.76%.

EURUSD
The Euro had a bit of a shocker yesterday, falling against the Dollar and Sterling. Perhaps traders are waking up to the fact that the commendably austere fatherland isn’t doing too well and that several other member sates are limping badly behind it.

The Euro is clinging to the uptrend line by the skin of its teeth; the price has fallen below the 10-day EMA, but will look for support from the rising 21-day moving average at around $1.3940. The RSI is still above 50, but showing a distinct lack of interest.

This morning has seen a weaker Dollar; no great surprise given a mild uptick in equities. The first test will be to see if the rate can survive the US session above $1.40, but I still see it capped by a downtrend line around $1.4110.

GBPUSD
As things stand the price has done well to take out the weekly bearish shooting star. There’s no arguing with the bullish technicals on the daily chart; a strong bounce off the 21-day moving average, back above the 10-day EMA tracker and a supportive RSI at 68. To me the chart’s pointing to a re-test of $1.6650 at least.

But I can’t help having this niggly feeling that’s come from being very involved in this trade, and it’s borne out by yesterday’s candle. There wasn’t much body to it, which suggests a lot of other traders aren’t too sure. This isn’t a negative sign, but it’s warning me not to get too gung-ho until either support is tested, and holds firm, on the downside, or I see a bullish pattern on the upside.

This morning’s rise up to $1.6490 re-asserted the bull trend for the time being. But that candle needs to hold good at the end of the day; if it loses momentum and ends up as another doji then this will add fire to the reversal argument.

I’ll finish by putting it into context; look at the slightly longer chart:

At the moment $1.6660 feels a bit toppy, but if the price can make a clean break above that level look at the potential profits for a long trade there!