This article is a guest post by Vince Fernando, The Business Insider.
Dollar strength at the end of 2009 sent the dollar carry trade (where by one borrows in dollars, then parks the proceeds in higher yielding assets) into a tailspin. This is why even small upward moves in the dollar could instigate substantial selling for 2009's star currencies. For example, for the Australian dollar shown to the right.
Bloomberg: Funding the carry trade with the greenback lost money in December for the first time since February as the U.S. currency gained 4.8 percent against the euro amid growing confidence in the U.S. economy and expectations that the Federal Reserve will raise borrowing costs by June. Futures trading on Dec. 31 suggested a 62 percent chance the Fed would increase its benchmark to at least 0.5 percent by mid-year from a range of zero to 0.25 percent, up from 30 percent in November, Bloomberg data show. The Bank of Japan’s target rate is 0.1 percent.
Buying and selling high- and low-yielding currencies to take maximum advantage of global rate moves gained 19 percent from February to November, the carry trade’s best nine months since 2003, a Royal Bank of Scotland Plc index shows. The index fell 0.9 percent in December.
Few engaged in such an arbitrage will want to hang around should last year's prevailing weak-dollar expectations be substantially reversed by persistent dollar strength.
[AA] Looking at the chart below of the dollar index, you can see that the dollar has rallied since the end of November, as a result of the accumulation of large short positions, not being covered. This has been a very profitable trade on both a currency pairs as well speculation in last year's winning trades.Currencies fared vary well against the dollar from an exchange rate standpoint as you can see in the following table:
| Currency Pair | Rate as of Jan 1, 2009 | Rate as of Jan 1, 2010 | *Percentage Change |
| AUD / USD | 0.6539 | 0.8929 | 36.54% |
| NDZ / USD | 0.5786 | 0.7255 | 25.39% |
| USD / CAD | 1.2184 | 1.0505 | 15.98% |
* reflects the percentage change in the value of the non-USD currency compared to USD
Is it really a surprise that risk assets (commodities, the Canadian and Aussie dollars, equities, emerging markets) are selling off as institutional and hedge fund traders unload this increasingly squeezed short trade?
Read Bob Janjuah's updated outlook for more insight on the short squeeze raising the dollar's value - Janjuah points out that Senator-elect Scott Brown's GOP victory in Massachusetts upsets Obama's applecart so much so, that the resulting backlash will be for Obama to speed up plans for fiscal tightening, which means possibly a more rapid windup of the Fed's quantitative easing, monetary tightening later this year.
Axel Merk puts it nicely, saying "In that context, the conventional wisdom that a country needs to have economic growth to have a strong currency is, in our assessment, wrong. Such a relationship only applies to countries that depend on foreigners to finance their deficits. In the U.S., foreigners finance the twin deficits; one of the reasons why the U.S. has economic growth as a top priority is to entice foreigners to keep financing U.S. deficits. Australia also has a current account deficit and, as a result, has a currency that is sensitive to economic growth prospects. Japan, however, traditionally finances its deficits domestically; as a result, the value of the yen is not very sensitive to changes in growth forecasts. The same can be said for the euro zone: because the euro zone does not have a significant current account deficit, in our assessment, the euro can do well in the absence of economic growth.
Source: StockCharts
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