Sarah O'Connor
FT Syndication Service
The fallout from the US rescue plan for Fannie Mae and Freddie Mac has sent dollar bulls scuttling for cover while raising the question: how much more pain can the battered US currency take?
Relief over the Treasury's announcement that it would seek to provide funding for the two US government-sponsored mortgage groups has quickly been replaced by fears that conditions in the financial system are worsening.
The dollar sell-off on the day after the announcement of the rescue plan by the US treasury was broad-based. It drove the euro to a record high against the US currency - taking it back above $1.60, while the pound broke through $2, to its highest level since March. The greenback also fell more than 1.0 per cent against both the Swiss franc and the yen.
The latest bout of weakness comes only a couple of months after some analysts had forecast a major improvement in the dollar's fortunes. Rising US inflation prompted tough talk from Ben Bernanke, the Federal Reserve chairman. He said the time of lower US interest rates was over, helping the currency to rally modestly between mid-April and mid-June.
His comments were immediately trumped, however, by Jean-Claude Trichet at the European Central Bank (ECB) who gave a clear signal that eurozone rates would soon be lifted. Mr Bernanke failed to back up his rhetoric with a rate rise, but Mr Trichet duly increased by 25 basis points to 4.25 per cent earlier this month.
"Currency markets will always favour those central banks that take the fight to inflation," says Neil Mellor at Bank of New York Mellon.
"And here the ECB is in pole position, while the Fed isn't even on the starting grid."
Ashraf Laidi, at CMC Markets, agrees that the Fed is hamstrung because it has a dual mandate to maintain employment and curb inflation, while the ECB just has an inflation target.
"The deteriorating market and economic conditions in the US continue to be the chief causes of the broad decline in the US currency," he says. "As long as these continue, the dollar will fall regardless of any jawboning by policy makers, which would be perceived as bluffing rather than communicating real policy intentions."
But some commentators believe recent waves of dollar selling have less to do with central banks and interest rates, and more to do with risk appetite.
"It's a drip feed of falling equities, particularly banks and financials, on to the dollar," says David Bloom, head of forex at HSBC. "We're slaves to all of this. We're not creating market moves or moving of our own accord."
Mr Bloom said his forex trading team was watching slumping equities carefully to gauge how far the dollar would tumble. "It isn't enough to just follow the main indices like the S&P, you have to look to aggregate indices for the banking sector, the brokers, the regional banks," he says.
"Suddenly in the FX market we've become experts on the components of equity markets," he adds. "We don't have a life of our own."
Hans Redeker, head of forex at BNP Paribas, says his team is watching the credit market for clues as to the dollar's next moves. He says in the past three months a very strong correlation has developed between credit default swaps - which measure the perceived riskiness of corporate debt - and the dollar.
Credit default swap indices have recently risen sharply as doubts about the solvency of Fannie and Freddie, as well as the demise of IndyMac, have reignited fears of systemic risk. Mr Redeker's team follows the fluctuations in the credit default swaps of major banks and brokers, though, he says, the iTraxx Europe index of major European corporate credits is also a decent indicator.
"An improvement in credit markets is one of the major conditions for a recovery in the dollar rate," he says.
But the US does not have a monopoly on fragile financial institutions. UK banks have also been badly burned by the subprime crisis, as have regional banks in Germany and Switzerland's UBS.
"The perception is the financial problems are worst in the US, followed by the UK, then Switzerland. It's about degrees of revulsion, and at the moment, the most revolting currency is the dollar," says Mr Bloom.
Mr Mellor agrees: "It's a matter of the ugly parade more than anything."
Finally, as the emerging markets around Asia struggle to battle double-digit inflation, an increasing number of central banks are using their dollar reserves to intervene in the foreign exchange market to shore up their own currencies in the battle to contain rising prices.
Around the middle of this month, it was estimated by traders that the Bank of Korea spent $8.0bn to slow the decline of its currency, the won. And Korea is not alone, with the Bank of Thailand and the Monetary Authority of Singapore among others thought to be actively intervening.
For now, sentiment is also very much against the US currency. Several analysts pointed to the fact that even though Germany's ZEW economic sentiment survey was much weaker than expected, the euro still rose.
Mr Redeker says: "The euro is rising not because it is a glorious currency, but because people are desperate to get out of the dollar."
