TOKYO -- The dollar's breakdown in the past few weeks may mean its stretch of ultra-low volatility is over, and traders are looking for opportunities to push the U.S. currency even lower and keep market swings sharp.
Coming events may help speculators stir more volatility, which fell to decade-lows on dollar/yen in October, as trading activity shrinks during the year-end holiday season.
A meeting of top Chinese and U.S. officials later in the week to discuss economic issues is feeding speculation that the yuan may be pressured to appreciate further, while the yen remains exposed to speculation over when the Bank of Japan will next raise interest rates.
The euro has shot up on an outlook for more interest rate increases next year based on solid euro-zone growth and incessant talk of central banks shifting reserves out of the dollar.
For six months the euro was stuck between $1.25 and $1.30, while sterling had trouble overtaking its late-2004 peak near $1.9550, prompting speculators and funds to trade in more active commodities than currencies.
Story Continues Below
With those ranges now history, speculators are likely to keep chasing both currencies higher.
"With talk of central banks shifting forex reserves into the euro, its downside risk is limited and makes for a good business buying the euro on dips to fan an uptrend," said Takao Hattori, a senior investment strategist at Mitsubishi UFJ Securities.
Some big speculators seized on thin liquidity around the U.S. Thanksgiving holiday to push the euro above $1.30, igniting a big rally that drove the single currency to 20-month highs at $1.3370 and sterling to a 14-year peak of $1.9849
"Dollar selling at a time when participants were scarce was a timely catalyst for the market reaching its limit on trading under months of historically low volatility," said a senior dealer at a major Japanese trading firm.
HUNGER FOR VOLATILITY
Implied volatility on one-month dollar/yen options a gauge of how much the market expects the pair to move over a given period, has jumped as high as 7.8 percent this month from a decade low near 6 percent in late October.
One-month euro/dollar implied vols rose to 7.7 percent this week from an all-time low around 5 percent.
Reflecting the renewed worries about sudden currency swings, one-week implied vols are now trading higher than one-month volatilities for a range of currencies.
Traders said there was momentum to push the euro above the peak of $1.3670 hit in late December 2004 in a holiday-thinned market, and sterling to $2.00 for the first time since 1992.
"The euro has become the speculators' target and they will likely test its new highs before momentum fades and expectations wane for aggressive monetary tightening next year," said one monetary source. "Sterling may also test fresh highs as its rise similarly reflects a simple bet on the direction of interest rates."
A further pick-up in volatility is likely if the euro hits fresh highs, said a senior trader at an European bank.
"The euro-zone economy should be able to withstand a higher euro, and given inflation concerns the tolerance for a higher euro is greater than in the past," said Joseph Kraft, head of foreign exchange and interest rates at Morgan Stanley in Tokyo.
But if volatility stays high, the downtrodden yen may finally recover as market players close out carry trades.
Carry trades involve borrowing in low-yielding currencies like the yen to buy higher-yielding ones and pocketing the difference in interest rates. The risk is that volatile currency movements wipe out the gains from the spread between rates.
The yen has been in a relatively narrow 10-yen range against the dollar this year, small enough to make carry trades safe. But a return to the wide 20-25 yen range of 2004/05 would hurt.
Some market players are hoping to keep volatility high.
Hedge funds are trying to force Japanese retail investors and margin traders to cover their short yen positions by pushing the dollar below 115 yen or 110 yen, traders said.
Yet carry trades remain popular because the yen's weakness has been so broad and the Bank of Japan is seen moving very slowly in raising rates from 0.25 percent.
The euro hit a lifetime high above 155 yen on Wednesday, while sterling and the Swiss franc touched eight-year highs. The Australian dollar is near its strongest in a decade against the yen.
"There has been a tug-of-war between carry traders and those who are trying to swing the market in favour of a strong yen," said Hiroshi Niwa, president of Phoenix Securities.
Copyright Reuters 2006. All rights reserved. Republication or redistribution of Reuters content, including by caching, framing or similar means, is expressly prohibited without the prior written consent of Reuters.
Editor's note:
Warren Buffett: I'm Betting Billions On A Falling Dollar
The Six Sectors Poised to Skyrocket as the Dollar Declines - Go Here Now
