King No More: U.S. Dollar Rally Ends

The dollar's sharp rally off Friday's unemployment report has evaporated. I take this as more evidence that the dollar is topping out.

Dollar/yen has traded all the way back down to around 108. Recall that the yen was just shy of 110 for $1 on Friday. Similarly, we have seen Friday's dollar gains against the euro, British pound, Aussie, the rest of the majors and even many emerging market currencies all unwound.

With respect to the euro, the currency does not seem to be reacting to weaker economic news anymore. Yesterday's German factory orders number was far weaker than expected and the euro rallied. As a trader, that usually tells me something. It would appear that in the near term, at least, a lot of the bad news has already been discounted.

There is also that massive short position that I have been talking about. Indeed, my whole entire characterization of the market for some time has been that speculators have been selling euro and yen short, with little or no understanding of the true effects of monetary policy measures that have been taken by central banks. Those short positions are humongous.

According to the CFTC the total short position by speculators in the euro as of last Tuesday was 288,376 contracts. That is equivalent to a $45 billion short position. The net short position (total shorts minus total longs) was 187,211, which is about a $35 billion short position. Still very impressive.

The yen is showing similar concentration. Total short positions by speculators in yen futures on the CME approached a notional value of nearly $26 billion, while the net short position came to around $20 billion.

Let me put this in perspective, because some might be tempted to say that in a $5-trillion-a-day market like forex, such numbers are pocket change. I could understand that argument; however, consider that the average size of a central bank currency intervention is something on the order of a few hundred million dollars.

I have a friend who is a senior FX dealer at a major global bank and when I asked him what is "large" for a central bank he said that a $1 billion intervention is considered very big. That's a "bazooka," to steal a term from Hank Paulson.

So speculators have shot about 50 bazookas in the euro and about another 26 in the yen. That's a lotta bazookas.

On the other hand, central banks like the ECB and the Bank of Japan can continue accommodating these nice spec chaps by "cashing them out" via further central bank currency sales (dollar purchases). We saw this back in June with the ECB, when it sold euros for dollars and we have seen it consistently over the past 12 months with the BOJ, which bought about $100 billion in that time.

However, unless the central banks keep accommodating the speculators, it's not likely this currency collapse can go much further. Indeed, as I said earlier, there are signs now that the selling is just not strong enough to keep the euro and the yen down.

Finally, it's important to remember that there is a political price to pay for a weak currency. Like anything else, it may be good for a while, but it tends to be a "sugar high," and as such it can backfire. For example, while some benefit (primarily exporters), the general public ends up suffering, because a falling currency makes lots of things more expensive.

Without a doubt, the quickest way to undermine support for your political goals is to turn the public against whatever it is you are doing. That might be exactly what is happening now, at least as far as the yen and euro are concerned, so don't be surprised if you hear bureaucrats and finance ministers saying things like "the decline has gone too far" in the coming days and weeks.