Sunday, May 24, 2009

US Dollar Strength Will Outlast Risk Aversion as Economy Recovers

The US Dollar has fallen sharply over recent weeks as a rebound in risky assets weighed on the safety-linked currency. Looking ahead, however, evidence continues to suggest that the sell-off is a correction in the context of a larger uptrend rather than a sustainable change in Dollar’s overall trajectory, whether or not it is driven by risk sentiment.

The US Dollar Has Been Driven by Trends in Risk Sentiment

Recent months have seen the US Dollar exhibit a very strong inverse correlation with trends in risk appetite. Indeed, the US Dollar Index’s link with MSCI World Stock Index (a composite metric tracking global stock performance) was as strong as -95.9% in mid-December and now stands at a formidable -85.4%. As global demand weakened, expectations of dour earnings weighed on stock markets and pushed traders to pull capital from equities and other risky assets to seek safe haven in the greenback: the US continues to have the deepest, most developed capital markets and the most stable geopolitical profile, making dollar-based assets the venue of choice for risk-averse investors. Since March 10th, this relationship has worked against the Dollar as equities rebounded, sending the greenback 7.95% lower against its top counterparts.

Risk Aversion Aside, the Outlook for the Dollar Remains Bullish

Despite the recent selloff and taking risk aversion out of the picture, the case for US Dollar strength still looks compelling. The latest economic forecasts reveal expectations that US economic growth will outpace that of most other developed economies by the second half of this year, with differentials remaining in favor of the States into 2010. This suggests that the US Federal Reserve will lead its top counterparts in starting to raise short-term interest rates, boosting demand for Dollar-denominated assets.

Further, the US government is almost certain to issue billions in Treasury bonds to finance the tremendous amount of deficit spending that has been undertaken to combat the current crisis. This likely flood of government debt will send Treasury prices lower and add substantial upward pressure at the long end of the yield curve. The US fiscal effort dwarfs most anything else undertaken in industrial economies thus far, suggesting yields on US government bonds will see a far greater boost from new debt issuance and thereby become comparatively more attractive to investors.

Will Quantitative Easing Undermine the Dollar?

A chief concern about the US Dollar’s future prospects has been the Federal Reserve’s policy of “quantitative easing” (QE), a method of targeting long-term lending rates with the goal of adding to monetary stimulus as short-term borrowing costs approached 0% with no visible sight of improvement in economic activity. Put simply, the process works as follows:

1. The Fed creates some predetermined amount of new money (which is can do as the steward of the money supply) and uses it to buy government bonds from banks in the open market.
2. Because the supply of bonds has been reduced, their price goes up. This means that the yields required to make them attractive investments are reduced.
3. The banks that sold the bonds to the central bank now have more money on hand that they are able to lend. Because the yield on bonds is now lower, lending money to someone other than the government (i.e. individuals or businesses) at a higher rate becomes more lucrative, spurring credit access to the private sector and encouraging economic activity.

The chief concern with QE has been a fear of what printing money “out of thin air” will do to inflation once global economic growth rebounds in earnest. Assuming the scheme works as intended, the extra money divined by Fed will enter into circulation, making the US Dollar more abundant. As with anything made more readily accessible, the currency’s value will decline, leading to an “artificial” spike in prices. Depending on the size of the monetary injection, prices could skyrocket so dramatically as to erode the Dollar’s status as a store of value and effective medium of exchange, undermining economic activity altogether.

While such fears are reasonable, it is not entirely guaranteed that it will necessarily materialize. Monetary efforts to boost access to lending have been coupled by a massive jump in government spending. As we mentioned above, this spending has will need to be financed by borrowing. The issuance of new government bonds will pressure yields higher, attracting investors and working against the depreciative effects of QE. Assuming the Fed does not print so much money as to offset the impact the forthcoming demand for Treasuries, it is reasonable to expect a boost in demand for the greenback at the expense of nearly every other major currency.

1 comment:

  1. That is an interesting article. I however disagree and I will not go into to much detail however I believe that the Dollar will continue to weaken because the currency is being spread too thin as we are printing money and taking debt.

    However either way, I will be trading smart so no matter what happens I will profit.