On May 2 we published an item titled "Euro hits knockout." We pointed to the existence of so-called "knockout" contracts written by certain sellers of U.S. dollar/euro contracts.
These contracts have a cap of $1.3700/1 euro. The cap limit ($1.3700) to the writers' risks, allows the contracts to be sold for less premium.
We pointed out that the existence of these "knockout" contracts represented a considerable resistance level to the dollar price of the euro.
The U.S. dollar was plunging. Many forecast it falling even further.
No sooner had we put out our item on the existence of "knockout" contracts at $1.3700, than the U.S. dollar ceased its plunge and began to flatten out and hover.
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It appeared that the "knockout" contracts did indeed present a "resistance" level and time for thought.
On May 9, the Fed announced no change in its rate, but re-affirmed its focus on an inflation rate hovering stubbornly above its "comfort zone."
This sign of this apparent determination by the Fed to deal with inflation, gave the financial markets the unpleasant feeling that Fed rates will not come down anytime soon and could even rise.
The bond markets lost ground. The stock markets spluttered. The dollar started to gain ground and now stands at around $1.3543 to the euro.
[Editor's Note: 4 Foreign Currency Plays to Beat the Falling Dollar. ]
The recent plunge in the dollar has been influenced by the fact that, as we have often cited, our Fed has a dual mandate, unlike its most important competing central banks.
Our Fed's obligation to combat inflation and to encourage economic growth has caused many traders to feel that U.S rates must fall to off-set a slowing economy, made worse by a continuing housing bust.
They tended to sell the dollar short. Indeed it became somewhat fashionable to talk the U.S. dollar down.
We feel that the threat of a housing led recession is very real and must concern the Fed deeply. This is especially so in face of an election in 2008.
However, we think that the Fed is quite genuine in its fear of and focus on inflation. In a normal year, this would indicate a likely increase in the Fed rate. But, as we have said, this is not a normal year.
We believe that the counteracting forces of inflation and recession are mounting fast upon the Fed to such a degree that the Fed is now under extreme pressure. As a result, the outlook for Fed rates has become more than usually uncertain.
It appears to us that the options of up, hold or down are now worthy of equal probabilities of 33 percent each.
[Editor's Note: Bernanke Reveals `Fiscal Crisis` Ahead]
We feel that by banking upon a fall in Fed rates, much of the recent selling of the U.S. dollar became not only a fashionable talking point but also a self-fulfilling prophesy. Indeed, it may already have been overdone, with very heavy, speculative short positions.
The past few days have shown us that the currency markets are more than usually sensitive to an upward change in Fed rates, with the threatening possibility that some major short positions could be squeezed severely if the Fed were to come down firmly in defending its inflation "comfort zone".
It is likely that the next few weeks will become an increasingly testing time for both the Fed and the U.S. dollar.
We urge our readers to be very cautious in selling the U.S. dollar, until the fortitude of the Fed has been more tested.
Editor's note:
Bernanke Reveals `Fiscal Crisis` Ahead
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4 Foreign Currency Plays to Beat the Falling Dollar.
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