Volatility tests the nerve of the dollar bulls

Dollar bulls have hit a rocky patch. Buying the US currency has been the favoured trade of currency investors since last year's taper tantrum, when the Federal Reserve said it would ease its bond-buying scheme as the economy showed signs of improvement.

Now, investors are arguing that last week's flash crash in US bond yields was a wake-up call that volatility will make buying the dollar a trickier trade in the weeks and months to come.

"I expect volatility to rise and sentiment to continue to ebb and flow but ultimately still expect the dollar to strengthen, albeit with a lot of disappointment along the way," says Matthew Cobon, a currency investor at Threadneedle.

The dollar index rose more than 7 per cent in the three months to the start of October to hit its highest level in more than four years, buoyed by expectations the US would tighten interest rates sooner than other major economies. The contrast with the eurozone has been particularly stark, with the European Central Bank instead stressing a shift towards asset purchases to stave off the threat of deflation.

Yet the dollar has hit a rocky patch. Concerns from Fed officials that the US currency was too strong at the start of October had already seen the dollar index fall 2 per cent from its peak this month. Last week's flash crash in US bond yields, which investors say was probably driven by jitters over the health of the eurozone and gloomy prospects for global growth, as well as overcrowded trades, meant it lost more ground.

Yet investors say the bullish case for the US currency is still hard to ignore. Analysts argue that even if the Fed raises rates later than previously expected and the domestic economy is dented by lower global growth, the economic divergence between the US and many other major economies will still hold.

"The good thing is it doesn't take much tightening for the dollar to stand out versus zero rates as far as the eye can see," says Alan Ruskin, a strategist at Deutsche Bank.

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"It's not persuasive that the US economy is tanking," says Stephen Jen, head of hedge fund SLJ Macro Partners. "The dollar is still a very clear trade: it is a play on economic divergence."

Referring to recent suggestions the Fed could delay the end of its bond-buying scheme, he adds: "What's happening in Europe is real. What's happening in the US is not real: the fear is not justified and the Fed is confusing matters."

In particular, some doubt that the relative strength in the dollar is really hurting US companies. Win Thin, a global currency strategist at Brown Brothers Harriman, says the negative impact of a stronger US dollar on companies' earnings has been "inflated".

"This week IBM tried to blame the dollar for the poor results in the past quarter. But frankly, most companies of that size have very well-developed hedging strategies in place," he says.

"This year, the dollar has been strong and the US stock market has kept challenging new highs," he adds, arguing that when the Fed does raise rates, it will attract investors to US companies and strengthen the dollar at the same time.

Dismissing the concerns of traders over volatility, Jack Ablin, chief investment officer at BMO Private Bank, says: "This is a classic Wall Street versus Main Street argument. We obsess about Wall Street, when in fact it is Main Street that moves this economy and for most American households, this combination of a stronger dollar and lower energy prices should be considered as a tail wind."

Still, investors are being selective in how they buy the dollar. Trading it against the pound- with the Bank of England also looking at rate rises sooner than other major central banks - or the yen, which is one of the most likely currencies to benefit from haven trades if the global economy worsens, is seen as riskier.

Mr Jen says it makes most sense to buy the dollar against the euro and commodity currencies affected by the fall in oil prices, such as the Canadian, Australian and New Zealand dollars. Geoffrey Yu, an analyst at UBS, recommends buying the dollar against emerging market currencies that are overvalued, especially those likely to fall in line with commodity prices, such as the South African rand.

The next big event risk for the dollar will be next week's Federal Reserve monetary policy meeting, which will clarify the central bank's stance on ending its bond-buying programme. The effects of the slowdown in global growth could take longer to predict. "Dollar bulls need to be patient," says Mr Yu.

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