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John Authers

The Short View: Foreign exchange

By John Authers, Investment Editor

Published: August 14 2007 18:07 | Last updated: August 14 2007 22:18

Government bonds, then credit, then money markets – and now currencies. Like those other markets, foreign exchange trading is moving away from extreme levels, and reversing long trends. Like other markets, this is driven by the “Great Unwind” – a disorderly retreat from excessively cheap risk which, Tuesday’s renewed stock sell-offs show, is not over.

On Tuesday, some fundamentals pushed markets further in the direction that the unwinding was taking them. UK inflation came in way below forecast, within the Bank of England’s targets. So higher interest rates were not the inevitability many assumed, and the pound dropped below $2 for the first time since June. The dollar has now gained 3.1 per cent against sterling in three weeks.

In the eurozone, drab growth numbers raised more doubts about whether the European Central Bank would raise rates next month. The euro has dropped 2.1 per cent against the dollar since July.

The retreat from risk is more important than fundamentals. US investors have invested heavily outside the US. Faced with subprime losses, they have taken profits. The net effect is to buy dollars.

Then there is speculation. Marc Chandler, strategist at Brown Brothers Harriman, says the dollar, like the yen and the Swiss franc, has become a “funding currency”: traders sell the dollar short, and use the profits generated as it falls to invest elsewhere. As they lose on those other investments, they remove their “short” positions – or, in English, buy dollars.

This phenomenon is clearest in the 13.9 per cent rebound of the low-rate yen against the high-rate New Zealand dollar.

Fears about liquidity also matter. Speculators buy Canadian commercial paper – short-term borrowings backed by assets – to bet on Canada’s dollar rising. Now commercial paper issuers say no one will lend to them. This has helped push the US dollar up 3.1 per cent against its northern cousin.

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