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DOLLAR BULLS WAKE UP TO US REALITY

AT the start of the year, I wrote that the biggest nightmare facing dollar longs would be the prospect of a failed US Treasury auction creating massive capital outflows from dollar-denominated assets. For a while those worries appeared misplaced as the greenback rallied on the safe haven bid.<br /><br />Now the full force of those fears has hit the currency market. The dollar has weakened for several months as hopes of a recovery spurred investors to diversify into riskier currencies like the Australian dollar, the British pound and the euro. With global equity markets rallying through March and April, the dollar declined in a classic move towards more risk.<br /><br />However, risk aversion rose and equities wobbled last week, but the dollar continued to fall, demonstrating none of its safe haven appeal. In a massive shift in sentiment, the dollar is now perceived as the epicentre of risk. Why? Currency traders have realised that the US government will need to finance a budget deficit of nearly $2 trillion this year.<br /><br />Will foreign investors continue to lend money to the US at current low rates? The bond market certainly didn&rsquo;t think so, with yields rising last week to their highest level in six months as the US government prepared to auction off more than $100bn. Indeed, the Treasury auction should be the critical economic event on the calendar this week. While few fear a true failure, a weak response could send the dollar plunging to new yearly lows.<br /><br />The key metric to watch will be the 2:1 bid-to-cover ratio (meaning the US Treasury was able to attract two or more bids at the current interest asking price for its securities). If the auction is successful but the ratio slips below two, traders are likely to react negatively as it would signal declining demand for US fixed income assets just when America&rsquo;s financing needs are increasing exponentially.<br /><br />Boris Schlossberg and Kathy Lien are directors of currency research at GFT. Read daily commentary at www.GFTUK.com/commentary or e-mail BorisandKathy@gftuk.com.