The US dollar's thrashing on Thursday after a last-minute European deal to contain the debt crisis may have sealed the currency's fate. And it is all downhill from here. The European agreement, which involves a 50 percent write-down of Greek debt and boosting the euro zone's bailout fund to as much as 1 trillion euros, has averted a collapse in Europe and spurred a rush to risky currencies and assets once again at the expense of the dollar.
---- Dollar still main funding currency after EU deal
---- EU agreement temporarily plugs leaks
----- FX options market show global optimism
Add in to the mix: a suddenly revitalised US economy that a few weeks ago was teetering on the verge of recession and had fuelled speculation about another round of quantitative easing. Almost overnight it leaves a whole new global outlook that appears a little more encouraging.
The dollar, with its near-zero interest rates guaranteed over the next two years, is the first to get sold off in times of global optimism, as investors use the greenback to fund the market's foray into risky trades. "When economic conditions are not deteriorating, there is a general risk-loving mode and the dollar will remain the primary funding currency," said Alessio de Longis, portfolio manager for the Oppenheimer Currency Opportunities Fund in New York.
Oppenheimer has assets under management of $163.52 billion as of September 30. "There is a deployment of capital from the United States to the rest of the world. As the risk of collapse to economic growth diminishes, investors are slowly but surely putting capital back to work," said De Longis.
On Thursday, the greenback plunged to a seven-week low against the euro and plumbed multi-week troughs versus the Australian dollar and Swiss franc on the back of the European deal. And while the EU agreement is far from perfect, with the details to be finalised by the end of the year, it was a step in the right direction and has boosted market confidence markedly.
"The deal has stopped the rot and plugged the leak. The ship needs to sail in the right direction and this deal has helped it do so," said Steven Bell, portfolio manager and director of global macro hedge fund GLC Ltd in London. GLC has assets under management of about $1 billion. "The process has been chaotic, with a lot of back and forth on the summit, but the euro in its sort of funny, old messy way gets there even as the pressure mounts," said Bell, whose fund currently has no position on the euro.
FX OPTIONS DISPLAY OPTIMISM The currency options market is indicating a fair amount of optimism as well. Implied volatility on one-month euro/dollar options, a gauge of expectations regarding a currency's price action, dropped on Thursday to 13.30 percent, from 14.85 percent late on Wednesday. Declining volatility suggests investors are not as worried about the situation in Europe and therefore see less need to hedge against any negative event that may come out of the region.
Even sentiment on the euro, which has been fairly downbeat the last few years improved on Thursday based on the risk reversal measure in the options market. And while investors in general still expect the currency to decline, risk reversals have come off extreme levels. On Thursday, one-month risk reversals in euro/dollar showed bias for euro puts, improving to -3.3 vols, suggesting the market is expecting more declines in the currency, from as low as -3.9 vols late on Wednesday.
NOT STRAIGHT LINE FOR THE DOLLAR But as in any market, the dollar's decline won't be straightforward. Indeed if the implementation of the EU agreement stalls or if there is a sudden freeze-up in global credit, investors are likely to buy dollars, as they have always done in the past in times of market stress.
"We are in a situation where banks are generally deleveraging and that I think has implications for dollar credit," said Jens Nordvig, global head of G10 FX strategy at Nomura Securities in New York. "If the creation of dollar credit gets impaired, that could be supportive of the dollar." But that's something few investors are worried about right now as global central banks have been more than willing to provide liquidity to banks through their swap lines. In the meantime, the trend to sell the dollar is in full swing and not many are willing to go against it.