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IN BLOOMBERG 2009-06-22

«Analyst forecasts about the dollar have become the most scattered in two years, driving up foreign- exchange price swings and increasing risks that trading strategies and corporate hedges will backfire.

Redtower Asset Management, an Aberdeen, Scotland, investment adviser, sees the currency strengthening to $1.16 per euro by year’s end, from $1.3849 today, as the world economy recovers from the first global recession since World War II. Standard Chartered Plc predicts a more stable economy will weaken the dollar to $1.55 as the Federal Reserve keeps its benchmark interest rate near zero to sustain growth, prompting investors to sell greenbacks for higher-returning assets.

The 39-cent gap between the high and low calls in Bloomberg’s strategist survey is almost double August 2007’s 20- cent divide. Wider fluctuations increase the risk for so-called carry trades, where money borrowed from countries with low rates is used to invest for higher yields. A move to unwind such investments probably would drive down the Brazilian real, South African rand and other developing nations’ currencies.

“It’s usually in this environment when volatility starts to pick up, before you have a real big move toward one camp,” said Paresh Upadhyaya, who helps manage $21 billion in currencies as senior vice president at Putnam Investments in Boston. “The dollar’s at a critical juncture, and to me it’s a sign we’re going to see a more significant move one way or the other.”

‘Cost Headwinds’

Foreign-exchange swings are bedeviling exporters as they try to protect overseas earnings. Pittsburgh-based H.J. Heinz Co., the world’s biggest ketchup maker, said on May 28 that its profit fell in the previous three calendar months in the face of “significant FX-related cost headwinds.”

“Currency volatility is running at more than double the norm,” Barclays Plc President Robert Diamond said at a June 17 investor conference. “Volatility can have a devastating impact on corporate performance,” he said. “Clients are looking to us to provide strategic solutions.”

The forecasting disarray makes some companies dubious those services will do much good.

“The best-paid professionals out there simply do not know what’s going on,” Toby Nicol, director of communications at Luton, England-based EasyJet Plc, said in an interview on June 17. “How can a company’s treasury department be expected to know what’s going on?”

Increased Volatility

Among Group of Seven currencies, price fluctuations rose the most in May since October, when they hit a 16-year high, according to JPMorgan Chase & Co.’s benchmark index of so-called implied volatility. After the G7 Volatility Index dropped to a seven-month low six weeks ago, it jumped 1.2 points to 14.4 percent on June 19. The 10-year average before the 2008 credit crunch was 9.9 percent.

A strategy that bets on currency swings falling lost money in May for the first time since October after its best six-month run since at least 1974, an ABN Amro Holding NV index shows. Investors fled the carry trade last year as volatility increased and returned this year as swings diminished. The risk of a quick turn in exchange rates eating up profits is on the rise again.

“You’d earn your carry, you’d earn your price appreciation, and all this yield you’d had over two years disappears in an extremely short time of 48 to 72 hours,” said Werner Eppacher, head of foreign exchange at Deutsche Bank AG’s DWS investment unit in Frankfurt, who trades about $6 billion a year in his currency funds.

Investing in Uncertainty

Eppacher purchased options giving DWS the right to sell the Brazilian real, South African rand and Turkish lira against the dollar because emerging-market currencies that have had “a pretty good run” will suffer from increased volatility. Buying such contracts is “a good way to invest into this uncertainty,” he said.

The real and the rand are the best two carry-trade performers against the dollar this year among 35 currencies tracked by Bloomberg, returning 22 percent each.

The greenback weakened against the euro from early 2002 as U.S. budget and current-account deficits widened. When the economic crisis exploded in mid-2008, it surged 30 percent in three months to a two-year peak of $1.2330 per euro on Oct. 28 as investors fled to Treasuries. It then weakened to $1.4719 on Dec. 18, before bouncing back to $1.2457 on March 4.

Since then, it has weakened 10 percent as investors began taking more risk. The Standard & Poor’s 500 Stock Index rose 29 percent in the same period and 10-year Treasury yields climbed as much as a percentage point to 4 percent, pushing prices down to a seven-month low.

Borrowing Dollars

The divergence in opinions on what comes next stems from splits over the sustainability of a global economic recovery, the future of the dollar as the world’s reserve currency and the U.S. government’s record borrowing and spending plans.

Callum Henderson, the Singapore-based head of global currency strategy at Standard Chartered, a London bank that focuses on emerging markets, said he is bearish on the dollar because a more stable global financial system will lead investors to sell the U.S. currency in carry trades.

“Hedge funds use the U.S. dollar as a main funding currency for investing in higher-yielding assets,” Henderson wrote in a June 18 research note. “We expect this to continue, barring occasional periods of correction, well into 2011 in a similar pattern to 2002-2004,” when the dollar fell 34 percent.

‘Best Game’

Gerry Celaya, chief strategist at Redtower, said a global recovery will have the opposite effect, causing the dollar to strengthen as growth in the U.S. boosts returns on American stocks and government bonds.

“The dollar is the best game in town,” Celaya said. “The bonds will be bought. And if yields go higher, that’ll be an attraction for dollar investors versus other countries. More importantly, the stock market does continue to perform in the face of higher yields.”

Samarjit Shankar, a director of global strategy at Bank of New York Mellon Corp. in Boston, said the U.S.’s unprecedented efforts to fund a recovery will probably end up hurting the dollar. The U.S. has spent or pledged, via loans, guarantees and asset purchases, the equivalent of 80 percent of its $14 trillion economy, according to an April 26 report by the International Monetary Fund.

Shankar predicts the flood of debt will help push the dollar to $1.48 per euro in the next six months, as the currency is weakened by market perceptions that the government has borrowed too much and speculation that other countries will slow their purchases of U.S. assets.

Record Debt

Goldman Sachs Group Inc. estimates that President Barack Obama’s plans to stimulate the economy will increase debt sales to a record $3.25 trillion in the fiscal year ending Sept. 30. The borrowing has prompted both Russian President Dmitry Medvedev and China’s central bank Governor Zhou Xiaochuan to suggest the world may need an alternative to the dollar for settling international debts.

“Market participants are talking about the fact that central banks worldwide want to be able to diversify from their U.S. Treasury holdings,” Shankar said in an interview. “Given the huge Treasury supply in the pipeline and the budget deficits, it’s almost inevitable that the dollar’s going to be entering a period of secular decline.”

The government is scheduled to sell $40 billion in two-year notes on June 23, $37 billion of five-year debt the following day and $27 billion of seven-year securities on June 25.

Most Liquid Market

Christoph Kind, head of asset allocation in Frankfurt at Frankfurt-Trust, said he discounts talk that foreign governments will slow their purchases of U.S. assets. At the end of 2008, the dollar accounted for 64 percent of central bank reserves, up from 62.8 percent in June 2008, according to the International Monetary Fund in Washington.

“The U.S. still offers the most liquid and diverse capital market in the whole world,” said Kind, whose company oversees about $20 billion. “Last year, the dollar didn’t suffer even though the whole financial system in the U.S. was about to collapse. The dollar system is quite stable.”

Gerardo Margolis, a trader for emerging-market foreign exchange at TD Securities Inc. in Toronto, said the housing and banking industries will probably face more losses, buoying the dollar at the expense of currencies in developing nations as investors get out of riskier investments.

The world economy will contract 2.9 percent this year, the World Bank said in a report today, compared with a previous forecast of a 1.7 percent decline. Growth will be 2 percent next year, down from a 2.3 percent prediction, the bank said.

Emerging Currencies

“Commercial real-estate may have problems, and European banks are still undercapitalized, so all that is eventually going to flow into the market and lead us to another period of volatility,” Margolis said. “Volatility is probably going to pick up and hurt emerging currencies in the last quarter of the year.”

The European Central Bank said on June 15 that commercial banks in the 16-nation euro region may lose another $283 billion by the end of next year as the financial crisis forces them to write off bad loans.

Deutsche Bank AG is bullish on both the U.S. economy and the dollar, mainly because it’s bearish on Europe. Its forecast of $1.20 per euro “is based on expectations for wider yield differentials between the U.S. and the euro zone, reflecting relatively weaker growth in Europe,” said Henrik Gullberg, a currency strategist at the bank in London»