The dollar is a tough act to follow

WITH speculation growing that the dollar could be forming a short-term top, Deutsche Bank has released research suggesting “an increasing likelihood of dollar correction”. The bank suggests that the dollar’s rally to over two standard deviations above its 200-day moving average is a strong indicator that a dip could be imminent.

As the bank reports, only on seven occasions in the last 20 years has the dollar been overbought so far from its average (see chart) and “each time the dollar rally has over-run to this extent, a significant pull-back has materialised.” But if the dollar dips, which currencies can investors expect to see rise?

One factor driving the dollar rise is the flight towards a safe haven currency in volatile times. Over the past eight years, investors have diversified by buying the euro, which is now involved in over half of all dollar index trading. So the possibility of a dollar correction might prompt a switch back to the single currency. Bank of New York Mellon’s Simon Derrick says: “Over the course of the last two weeks there has been quite a bit of buying back of euros precisely because people have been looking for some kind of correction to take place.”

But with ongoing uncertainty, including Friday’s downgrade of Spanish debt, this might be unwise. Derrick sees the euro buy-backs as no more than a rebalancing of the extreme shorts seen two weeks ago. The overall trend for the euro is downwards: “So much of this is not about the dollar; it’s about a loss of faith in the euro.”

Likewise, Deutsche Bank advises that investors looking to short the dollar “are better off positioning themselves in the more equity-sensitive “high-beta’ European currencies” such as the Swiss franc, Norwegian or Swedish kronor and sterling. While all of these currencies look overbought, it is by significantly less than the dollar. Still, Derrick recommends staying clear of Europe entirely: “The only currency I’d really consider as a credible alternative is the Canadian dollar.”

Investors might look at the yen, which is trading close to its 200-day moving average. But a dollar-yen downslide is limited by potential market intervention. As Michael Hewson of CMC Markets says: “The bank of Japan will not tolerate a strong yen because it will harm its exporters, who are important for economic growth.”

So investors must look further afield. If equity rises make increased risk palatable, traders could consider the Australian or New Zealand dollar, which both show high intra-day correlations with the greenback. Or, with the Pru-AIG deal in doubt, Hewson says: “sterling could be buoyed up in the short-term” – perhaps for just long enough to catch a dollar downslide.

But a dollar correction could be fleeting. The continued European debt turmoil means that the greenback is still the only safe haven. As Derrick says: “The largest alternative reserve currency, the euro, has suddenly come into question and investors are placed in the position of trying to find credible alternatives.” Unless investors find one, a big dollar correction could prove elusive.