Is a one-way bet on the dollar rising still such a safe bet?

February 4, 2015

Traders work on the floor of the New York Stock Exchange

Borrowing in dollars is like playing “Russian roulette”, India’s central bank chief Raghuran Rajan said on Bloomberg TV this week.

With the U.S. Federal Reserve poised to raise interest rates and other central banks moving the other way, it’s a very dangerous game to try to place exact bets on how much the dollar could rise against other currencies.

But the clear and present danger already may be on the wane.

A Reuters poll on Wednesday showed foreign exchange strategists, unfazed by last month’s sharp volatility and policy surprises, have held on to forecasts of only modest gains for the greenback against key emerging currencies.

The biggest risk, instead, may be to see the Fed walking back from its plan to raise interest rates from a record low of 0-0.25 percent around the middle of this year.

That would allow room for currency gains from Asia to Latin America.

Berkeley professor Barry Eichengreen voiced that same concern a few weeks ago in an article titled “Don’t bet on a stronger dollar.” With so much currently staked on the market moving in one direction, it is worth contemplating the consequences of surprise events, such as disappointing U.S. growth, that could change expectations.

“The dislocations could be severe”, he warned.

The reality is that collecting wisdom on where exchange rates will go are usually wrong. Very few individuals actually manage to get it right.

One year ago, few if any strategists anticipated the panic that would sweep through emerging markets at the first concrete signs the Fed was ready to cut back and eventually shutter its bond-buying program.

Rajan may be right about Russian roulette, leaving aside the incredible plunge in the rouble over the past several months.

Bullish dollar cycles are not usually counted in months, but rather in years. And even if it doesn’t raise rates this year, the Fed probably will be the first among major central banks to tighten policy. If it can’t raise rates, none of its peers will be able to follow.

But the impact on foreign exchange markets may not be as brutal as he feared.

The chart below shows how much key emerging currencies have lost since May, some to decade or even record lows.

The question nobody really can answer with any conviction is: how much lower can they go?

rajan

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