The dollar fell sharply on Friday, pushing the euro above $1.31 for the first time since April 2005, on concerns about central banks diversifying their reserves and the greenback's narrowing yield advantage over other currencies.
The dollar's fourth consecutive session of weakness was the culmination of a host of negative developments over the last several weeks, including weaker-than-expected US economic data and comments from central banks in Asia and the Middle East underscoring the risk of keeping large reserves of dollars.
"It is the aggregate accumulation of these bearish bits and pieces that has the dollar on the defensive," said Dennis Gartman, an independent investment advisor who writes the Gartman Letter.
The euro had risen to its highest in 19 months, at $1.3109, a little more than 5 cents away from a record high set in late 2004. By mid-afternoon it was trading at $1.3100, up 1.2 percent from Thursday.
Sterling was up 0.9 percent at $1.9320, having hit a near two-year high of $1.9350, while the dollar sank to its lowest since June 2006 against the Swiss franc, at 1.2075 francs.
The dollar was down 0.5 percent at 115.75 yen, after dropping to a 2-1/2-month low against the low-yielding Japanese currency because of a broad unwinding of carry trades. In such trades, an investor would borrow yen and invest in assets denominated in a higher-yielding currency.
"The triggering of stop loss orders on Friday has intensified carry trade liquidation in a low liquidity environment," said Kathy Lien, chief strategist with Forex Capital Markets in New York.
Dealers also said the sharp drop in the dollar overnight had wrong footed some in the market, prompting a bout of rapid-fire short covering and a subsequent spike in volatility, which only weighed further on the dollar.
In the options market, implied volatility of 1-month to 1-year euro/dollar contracts rose sharply, suggesting heavy demand to buy options in anticipation of higher prices and higher spot market levels.
Next week's heavy slate of US economic releases, including the ISM manufacturing activity index, a gauge of core inflation and a revised look at growth in gross domestic product in the third quarter, could determine whether the dollar sustains this week's losses.
"We've had some pretty good numbers out of Europe, and so the risk for me is that over the next few weeks, we get some more sloppy data out of the United States in the manufacturing and housing sectors," Shaun Osborne, chief currency strategist with TD Securities in Toronto.
Thin volume has contributed to the dollar's 2 percent decline this week against a basket of major currencies, its largest weekly fall since at least July. Indeed, there were few catalysts overnight for the dollar's latest drop.
Wu Xiaoling, vice governor of the People's Bank of China, said in an academic paper that the reserves of East Asian nations were at risk from too much exposure to the falling dollar.
Investors are wary that China, which holds the world's biggest foreign exchange reserves of more than $1 trillion, might diversify out of dollar assets. Such speculation helped the euro rise to a record high above $1.36 in late 2004. Market positioning won't be a factor preventing a further decline in the dollar anytime soon.
Even though the greenback has sold off, J.P. Morgan said, speculative investors are holding a net short dollar position that's 1.1 times the average position of the last 12 months, the largest since early October. But that is not nearly as large as the 5 times average in April. Short positions are essentially bets that an asset price will fall.
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