Currencies: Carry trade puts US dollar under further pressure

The dollar sell-off has gained momentum. The dollar index, which tracks the greenback against a basket of major trading partners' currencies, slid by almost 2% last week to a 12-month low. The dollar has also hit a nine-month low against the euro. Mounting global risk appetite has reduced the appeal of the dollar as a safe haven, while the Fed's money-printing and the towering budget deficit have also undermined confidence in the dollar.

But there's another reason the dollar has weakened: it is now "the big funding currency" for the carry trade, says Jonathan Clark of FX Concepts. As they did with the yen, investors are borrowing dollars at tiny interest rates, selling them and parking the money in higher-yielding currencies.

That's because the dollar's slide is expected to continue now that panic has receded and US interest rates are unlikely to rise anytime soon. The Fed's interest rate is near zero and the three-month interbank dollar rate has fallen below that of the yen and the Swiss franc, while the dollar has also been less volatile than the yen of late, says Bloomberg.com.

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The short selling inherent in the carry trade puts added pressure on the dollar and reinforces its inverse link with risk appetite, says Hans-Gunter Redeker of BNP Paribas. But this also implies a substantial rebound if stockmarkets correct, as carry traders unwinding their bets by buying dollars would fuel the upswing. With risk appetite set to wane as growth weakens and the dollar looking cheap, it could recover to $1.20 against the euro by the end of June 2010, reckons Capital Economics.