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Dollar Intervention Risk `Meaningful’ on Volatility

Posted by smeddum on September 29, 2008

Dollar Intervention Risk `Meaningful’ on Volatility (Update2)
By Ye Xie

Sept. 29 (Bloomberg) — A growing number of currency traders and strategists are starting to speculate that finance ministers from the world’s biggest economies will join to support the dollar.

Volatility in currencies is the highest since 2000, when the so-called Group of Seven nations last intervened in the foreign-exchange market. The dollar weakened 2.5 percent on a trade-weighted basis in the past two weeks as the turmoil on Wall Street intensified. It had the biggest one-day drop against the euro since 2001 a week ago.

While the dollar strengthened 9 percent from its record low against the euro on July 15, wider price swings threaten to undermine confidence in the U.S. currency just as government borrowing rises and U.S. lawmakers prepare to vote on Treasury Secretary Henry Paulson’s plan to bail out the nation’s banks. The greenback is still down 23 percent since 2005.

“We’re getting closer to the right conditions for authorities to step in and prop up the dollar,” said Maxime Tessier, who manages $151 billion as head of foreign exchange in Montreal at Caisse de Depot et Placement. “The nightmare scenario will be a wholesale loss of confidence in the dollar.”

The dollar rose to $1.4500 per euro at 11:24 a.m. in Tokyo from $1.4614 on Sept. 26 after weakening 2.7 percent in the previous two weeks. The broader U.S. Dollar Index was at 77.531.

Even a hint that finance ministers may influence exchange rates may be enough to set a floor under the currency after efforts by the Federal Reserve, European Central Bank and Bank of Japan failed to revive investor confidence by injecting more than $1 trillion into the world financial system.

`Extraordinary Interventions’

“The central banks of the world have embarked on all sorts of extraordinary interventions,” said Stephen Jen, the global head of currency research at Morgan Stanley in London. “Currency joint intervention would be the least surprising. And it would probably be the cheapest.”

Morgan Stanley’s intervention watch index suggests an 18 percent chance that policy makers will step into the market to influence exchange rates. Any reading above 10 percent suggests the risk is “meaningful,” or elevated, according to the New York-based firm.

The index, based on interest rates, trading patterns and investor positions, is accurate 78 percent of the time. The index is at the same level as when the G-7 intervened in 2000.

Finance ministers from the G-7 are more concerned about rapid swings in exchange rates than the absolute level of currencies because volatility complicates the assessment of economies, interferes with monetary policy and gives companies little time to adjust by cutting costs.

`Sharp Fluctuations’

Sadia SA, Brazil’s second-biggest food company, posted a 760 million-real ($410 million) loss last week related to foreign-exchange hedges after the nation’s currency tumbled 26 percent from a nine-year high on Aug. 1.

The G-7, which includes the U.S., Japan, Germany, Britain, France, Italy and Canada, warned in April against the implications of “sharp fluctuations in major currencies,” the first time since 2004 that the group used such language. Shoichi Nakagawa, Japan’s new finance minister, reiterated that view on Sept. 26, saying “sharp fluctuations in the foreign exchange market aren’t good.”

Implied volatility on one-month euro-dollar options rose to an eight-year high of 15.55 percent on Sept. 18, the same level that triggered the G-7 to buy euros in 2000 to halt the 27 percent slide from its 1999 debut. Volatility gained to 14.78 percent from 14.51 percent last week, up from this year’s low of 8.02 percent on Aug. 1.

U.S. Growth

Weakness in the dollar hasn’t become so disruptive to suggest imminent intervention, said Ken Jakubzak, who manages the KML Currency Program in Chicago for KMJ Capital LLC, which has $100 million under management.

The currency is 3 percent stronger than its record low in March on a trade-weighted basis. Some investors say the currency may rally as the economies outside the U.S. slow.

Growth in the euro-zone will decelerate to 1.35 percent this year from 2.63 percent in 2007, according the median estimate of economists surveyed by Bloomberg. Japan’s economy may expand 1 percent, compared with 2.08 percent, while the U.S. economy will likely grow 1.7 percent, the surveys showed.

The dollar will rally to $1.43 by year-end and to $1.40 by the end of the first quarter, according to the median estimate of more than 40 economists and strategists surveyed by Bloomberg.

“Should the bailout plan succeed in stabilizing the markets, the sentiment will shift to be more constructive for the dollar,” said Jakubzak, who expects the dollar to rise to $1.30 by year-end. “What happens in the U.S. will also happen in the other places in the world.”

Paulson Plan

U.S. lawmakers are reviewing a tentative agreement to revive credit markets by authorizing a $700 billion plan to buy troubled assets from financial institutions. “The deal is done,” said Senator Judd Gregg, a New Hampshire Republican, a ranking member of the Budget Committee. The House and Senate may vote Sept. 29 on it, he said.

Dollar bears say the U.S. budget and trade deficits and negative real interest rates make a sustained dollar rally unlikely. Paulson’s plan to buy devalued securities from banks would drive U.S. government debt above 70 percent of gross domestic product, the most since 1954, based on economist estimates and details of the bailout.

Barclays, TD

If the Treasury spends the entire amount next year, it would drive next year’s budget deficit to $1 trillion or more from about $500 billion now. Michael Feroli, an economist at JPMorgan Chase & Co. in New York, estimated the combination of the Paulson plan, additional government expenditures, and a slower economy, may swell the deficit to $1.5 trillion, or 10 percent of GDP.

The currency will drop to $1.57 per euro by year-end, according to London-based Barclays Plc, the world’s third- largest foreign exchange trader. Toronto-based TD Securities, a unit of Canada’s second-biggest bank by assets, said it will weaken below $1.60 in the next few months.

“Authorities don’t want excessive dollar weakness to feed the sell-America mentality,” said Chris Turner, head of foreign exchange strategies in London at ING Groep NV, the largest Dutch financial-services company. “We are not there yet, but the risk is there. People I speak to are worried about a budget explosion.”

The government depends on foreign money to finance the budget deficit because investors outside the U.S. own 56 percent of the $4.8 trillion in marketable Treasuries outstanding, up from 42 percent five years ago, according to data compiled by the government.

`Been Crushed’

While the G-7 decided against intervening in April when the dollar fell below $1.60 per euro for the first time, tolerance for a weaker currency may be limited because of the turmoil sweeping the financial system. The next meeting is scheduled for Oct. 10 in Washington.

In the past month, the government took over Washington- based Fannie Mae and McLean, Virginia-based Freddie Mac, the two biggest mortgage finance companies, as well as New York-based American International Group Inc., the largest U.S. insurer. New York-based Lehman Brothers went bankrupt and Washington Mutual Inc. of Seattle was seized by regulators in the biggest bank failure in U.S. history.

“At the end of the day, the financial sector is our flagship,” Kenneth Rogoff, a professor of economics at Harvard University, and a former a former chief economist at the International Monetary Fund, said in an interview on Bloomberg Radio Sept. 19. “It has been crushed, and that’s going to have a big impact on international capital flows. That’s going to affect the positions of the dollar in the global financial system.”

To contact the reporter on this story: Ye Xie in New York at yxie6@bloomberg.net

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