Reasons to be cautious on wave of dollar optimism

By Jamie McGeever - Analysis

LONDON (Reuters) - Just as investors and forecasters form a consensus on the dollar entering a period of prolonged strength that could last for years, the caveats are materializing in tandem and some experts urge caution.

From shorter-term factors like the market's lopsided positioning to longer-term concerns over the perilous state of the U.S. economy, housing sector, banks and fiscal position, sustained dollar strength is by no means a given, contrarians argue.

The dollar has shown remarkable resilience in recent days to a jump in the U.S. unemployment rate to a five-year high above 6 percent and the de facto nationalization of mortgage giants Fannie Mae (FNM.N: Quote, Profile, Research, Stock Buzz) and Freddie Mac (FRE.N: Quote, Profile, Research, Stock Buzz), which potentially adds hundreds of billions of dollars to the U.S. budget deficit.

The dollar is on track for its biggest quarterly rise versus a basket of six major currencies .DXY since 1992 as investors repatriate foreign asset holdings en masse amid a renewed crisis of confidence in U.S. banks like Lehman Brothers (LEH.N: Quote, Profile, Research, Stock Buzz).

But in uncertain times, some argue, scared money comes home -- at least U.S. money. Having piled into foreign assets and markets during the dollar's decline in recent years, U.S. investors are now cutting those positions and bringing their cash back home.

But in a report titled "Has the World Gone Mad? Part 3: 'Liquidation', the Dollar and Geopolitics", Bernard Connolly at Banque AIG in London argues that the case for further dollar appreciation is still in the balance.

"We cannot stress our underlying point enough: for the recent dollar rally to be validated, there will have to be more policy support for U.S. domestic demand and there will have to be more government support for the financial sector," he said.

"In the absence of these things, the dollar rally can only mean higher unemployment, lower equity prices, worsened credit, increased financial-sector risk, higher required risk-premium in U.S. assets and ... a return to the risk of the vicious circle in the dollar and credit risk," he added.

There's a flip side to Connolly's argument which many dollar bears would also say is a threat to the currency. That is that U.S. interest rates staying low at 2 percent -- or even going toward 1 percent -- offers yield-seeking investors scant return.

Much was made of the dollar's initial turn in July of the Federal Reserve's indications around that time that its rate-cutting cycle was over. Futures markets quickly moved to price in up to 75 basis points of rate increases this year.

But that has since been obliterated and futures now see no rate rise until the middle of next year. At 2 percent, U.S. rates are less than half of those in the UK and euro zone.

IMABALNCE OF PAYMENTS

The credit risk of the United States government has for decades been considered to be the lowest on the planet, but it has risen markedly over recent months as the problems that led to the weekend bailout of the two big government-sponsored enterprises materialized.

The cost of insuring Treasury debt against default, as measured by credit default swaps (CDS), rose to a record high on Wednesday. That meant it cost $18,000 to insure $10 million of U.S. 10-year Treasury bonds -- more than Germany and many other European countries.

Strategists at Bridgewater Associates, a fund management firm based in Connecticut with $140 billion in global investments for institutional clients including foreign governments and central banks, believe the U.S. credit risk poses a serious long term risk for the dollar.

They argue the U.S. financial crisis is essentially a dollar-denominated debt crisis that will likely lead to the nationalization of large and unacceptable debts and a ballooning of the fiscal deficit that will put the balance of payments and dollar under severe pressure.

Only this week, the bi-partisan Congressional Budget Office said the U.S. budget deficit will swell to a record $438 billion next year.

And that's not including the costs of propping up Fannie and Freddie.

"If Fannie and Freddie hit the federal budget, the dollar rally may hit the rails," said Neal Kimberley, head of FX sales at BTM-UFJ in London.

For the dollar, whose lifeblood is deficit financing from abroad, this is a worry. The current repatriation stampede back into the dollar may soon fizzle out, leaving few fundamental reasons to remain a long-term buyer of the currency.

"I am not suggesting that once the market is out of risk it will be a return to a record dollar low versus the euro, but I do think we are due to see a healthy retracement of the 20-cent move from $1.60 (per euro) to $1.40 in eight weeks," said David Gilmore, partner at FX analytics in Essex, Connecticut.

A Reuters poll last week showed 35 of 41 analysts surveyed said the dollar has begun a multi-year recovery. On Thursday, the dollar index hit a one-year high.

But given current market positioning, a correction could soon be on the cards.

According to the latest weekly figures from the International Monetary Market on the Chicago futures exchange, speculators held a record long dollar position against major currencies in the week ending Tuesday last week.

Peter Frank, currency strategist at Societe Generale in London, said aggregate net 'long' dollar positions on the IMM totaled $13.5 billion a couple of weeks ago, among the highest on record.

That means speculators have been betting heavily on further dollar strength. It also means there's huge scope for these investors to cash in on the greenback's rally in recent weeks.

"The dollar's getting very, very reliant on external factors ... and it's looking very stretched," Frank said.

"The nationalization of Fannie and Freddie draws one line in the sand, and it helps. But there's still a lot of risk out there and it's largely dollar risk," he added.