Dollar drops as great sell-off looms

By Ambrose Evans-Pritchard

05/02/06 "The Telegraph" -- -- The dollar has tumbled to one-year lows against the euro and the lowest level since the 1970s against the Canadian dollar as the markets bet on an end to monetary tightening by the US Federal Reserve.

Greenback liquidation comes amid growing concerns that global central banks and Middle East oil funds are quietly paring back their holdings of US bonds.

The dollar dropped to $1.2680 against the euro and the yen gained sharply to 112.40, though it recovered some ground in New York on strong manufacturing data.

Gold leapt to a 25-year high of $660.95 an ounce on fears the dollar decline could spiral out of control, disrupting the global financial system.

Fed chief Ben Bernanke set off the slide last week by talking of a possible "pause" in interest rate rises, citing worries about the risks of a "pronounced housing slowdown".

The comments followed Fed minutes revealing that some governors feared "the dangers of tightening too much". Rates have risen 15 times to 4.75 pc since June 2004.

The dollar slide and the Fed's apparent willingness to wink at higher inflation has roiled the bond markets, where yields on 10-year Treasuries have spiked to 5.13pc, the highest in four years.

David Bloom, a currency expert at HSBC, said the dollar was vulnerable to a steep sell-off as investors began to refocus on America's yawning current account deficit, now 7pc of GDP. The currency has been boosted for more than a year by rising US interest rates, but the yield advantage could soon slip away as Europe, Japan, and China play catch-up.

"Beware regime change. When it turns, it will be totally poisonous for the dollar because the US will have to start paying investors for the risk of financing their massive deficits," he said.

Smaller central banks are already taking precautionary steps. Sweden's Riksbank has slashed its dollar reserves from 37pc to 20pc over the past month, while the United Arab Emirates said it is planning to switch 10pc from dollars to euros.

The combined dollar reserves of China and Japan are so vast - perhaps $1,400bn, mostly in US bonds - that they cannot easily be sold without setting off a global panic. However, the Bank of Japan has stopped accumulating US treasuries now it no longer needs to hold down the yen to combat deflation.

The fall may be checked, however, by the inherent weakness of Europe's monetary union. The euro's strength in early 2005 set off mayhem in Italy, prompting two ministers to float ideas for a return to the lira, largely to bail out struggling exporters.

The European Central Bank is already softening its monetary policy to try to dampen enthusiasm for the euro, stunning the markets last month by shying away from an expected rate rise in May.

"If the euro gets to $1.30 against the dollar there will be another chorus of complaint from the weakest states," said a veteran EMU-watcher.

"If it gets above $1.40, Italy will be blown out of the euro-zone."

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