A shrink­ing U.S. trade deficit will spur demand for the U.S. currency

The U.S. currency strengthened to $1.3582 versus the euro on May 11 from $1.4058 on Ian. 2. Against the yen, the dollar appreciated to p97.48 from a low of Y87.13 on Jan. 21.


To track the dollar using the FX Information Platform, which displays the latest headlines, market rates and economic statistics related to the greenback, as well as a menu of related functions.


The dollar, which benefited in the past 12 months as a deteriorating global economy sent investors flocking to the safety of Treasuries, is now gaining some support from signs the U.S. recession is easing. Consumer confidence rose in April by the most in two years, and the pace of job losses slowed, while a gauge of U.S. manufactur­ing activity had its bi: est. bounce since at least 2005, according to government and private data.


On April 24, finance chiefs from the Group of Seven industrialized nations said in a joint state­ment that they saw “signs of stabilization” and expect economic activity to pick up later this year.


“FOR THE DOLLAR, WS a Cyclical play,” says Brian Kim, a currency strategist in Stamford, Connecti­cut, at UBS AG, the world’s second-biggest foreign exchange trader.


“If the U.S. should lead the global econompurchase U.S. debty out of the downturn, we would think that would actually favor the dollar.”


Strength in the dollar maybe tempered if inves­tors become convinced that a global recovery is occurring and then pulls money out of dollar-denominated holdings to buy riskier, higher-yield­ing assets such as emerging-market debt.

Signs that investors perceive less risk in finan­cial markets can be seen in the currency options market, where the implied volatility on so-called butterfly options has declined since late Novem­ber.


Options are contracts that grant the right but not the obligation to buy or sell a currency at a specified exchange rate, or “strike price,” on or before expiration.


Investors use butterfly options, which involve options with three different strike prices and the same expiration date, to bet that the underlying currency won’t move much.


When volatility increases on such contracts, it indicates a height­ened risk of an event that might cause a swing.


IN THE LAST HALF of 2008, as the global financial meltdown roiled world markets, the implied vol­atility of butterfly options on the euro-yen cur­rency pair tracked movements in the dollar: As volatility on the options increased, which indi­cated that investors perceived more risk and a greater need for safety, the dollar rose.


When implied volatility in the options declined, so did the value of the dollar. Type EURJPY25B1Y <McCoy> DXY <Index> HS D <Go> to graph the relationship between the two gauges during the past 12 months.


This year, implied volatility on one-year but­terfly options has fallen steadily, signaling that investors may be more willing to move away from the dollar and into riskier assets.


That might lead to surges in trading of commodities and commodity-linked currencies, as investors re-enter those markets at the expense of havens such as the greenback. The Australian dollar, for instance, gained almost 8 percent against the dollar this year through May 11.


You can use the FX Volatility Surface (OVDV) function to analyze implied volatility on the euro-yen currency pair. Type OVDV <Go>, click on the arrow to the left of the first yellow field in the upper-left part of the screen and select EURJPY, or enter EURJPY in the field if it doesn’t appear in the list. Click on Charts on the red tool bar to graph the data.


The dollar may face into head winds as the Fed prints money to purchase U.S. debt in an attempt to keep yields from rising, says Jonathan Xing, who helps manage $18 billion in foreign exchange as a senior portfolio manager at Bank of New York Mellon Corp.’s Mellon Capital Man­agement unit in San Francisco. “You’re issuing your own debt and buying it back in the market­place,” Xing says.


Goldman’s O’Neill said in April that a shrink­ing U.S. trade deficit will spur demand for the U.S. currency.

Goldman's O'Neill

The drop to $27.6 billion as of March from as much as $62.5 billion last year “means this massive commercial overhang of Excessive supply of dollars coming from the trade defi­cit is basically being taken away,” he said. The Dollar Index largely followed the U.S. trade balance in