In early 2008, Lehman Brothers management increased the company's dividend even as its underlying credit quality was rapidly deteriorating. In a potential repeat of history, Jean Claude Trichet, the Chairman of the European Central Bank (ECB), hinted last week at a possible interest rate hike in the near future. The ECB raising its target interest rate while the solvency of many Eurozone members is in question will do as little for the Euro as Lehman Brothers raising its dividend did for its stock price.

The charts below show that market participants are becoming increasingly worried about the credit quality of many European governments. Although the possibility of higher interest rates may have caused speculators to buy the Euro, a rate increase will not solve Europe's problems.

Figure 1. One-Year Charts of European Government Interest Rates

Source: Bloomberg

Following Trichet's comments, speculators increased an already large short position against the Dollar to a multi-year high. Lopsided positioning by investors is usually a recipe for disaster. According to a Reuters article based on Commodity Futures Trading Commission data¹

Currency speculators boosted bets in favor of the euro to the highest since January 2008 in the latest week, while bets against the dollar jumped across the board, data from the Commodity Futures Trading Commission showed on Friday. The value of the dollar's net short position rose to $34.9 billion in the week ended March 1 from $22.36 billion a week earlier, according to CFTC and Reuters calculations. It was the largest net short dollar position for which Reuters has data, dating back to June 2008.

Shown below, the Dollar Index has reached a critical support level. Given that so many speculators are already short the Dollar, it will likely be very difficult for speculators to push the Dollar below the long-term support line. Instead, a strong rally by the Dollar could be ahead.

Figure 2. US Dollar Index Since 2005

Source: Barchart.com

Investors have embraced foreign currencies by aggressively shorting the Dollar. The ECB's recent indication of higher interest rates has added to the positive Euro sentiment that already exists. However, the recent surge in confidence in the Euro is questionable given the continued weakness in European sovereign debt. The combination of lopsided positioning against the Dollar, long-term technical support, and rising European sovereign yields suggests that the Dollar's next significant move will be higher.

¹ Reuters Article by Nick Olivari on March 4, 2011 (see: http://www.reuters.com/article/2011/03/04/markets-forex-imm-idUSN0422751120110304)