The US dollar remains under continued pressure from factors such as recovery hopes and inflation worries. However I question whether the market has correctly assessed the reasons why this is the case. In this article I analyse the issue and provide my conclusions on what is really behind this continued dollar weakness.
Central bank stimuli
A first argument that is raised in explaining current dollar weakness is monetary and balance sheet expansion by the Federal Reserve. The amount of liquidity the Fed has injected into the system is without precedent. The question though is whether this contributes to a fall in the dollar. For this to cause a drop in dollar value, credit growth by banks should rise. This is not the case right now as a lot of this money is still sidelined on balance sheets (and central bank reserve deposits) and does not boost economic activity. Thus we do not think that in this case this issue is creating selling pressure in the foreign exchange market.
Market inflation expectations
Since the implementation of the various stimulus packages that the US government instituted to bail out banks and regenerate the US economy, household deficit and national debt has been rising to potentially worrying levels. As a percentage of GDP one could argue that debt levels at 60.3 per cent are still manageable. In nominal terms however, $8.8 trillion is an excessive amount.
As the market has begun to take in this level of debt, it has started to assess the long term risks, particularly with regard to (hyper) inflation. If this is a real worry, then of course the USD will suffer as a consequence. However, inflation expectations have been fading away from the forward market since July 2009. So this does not explain current dollar weakness either.
The recovery argument
We believe that recent comments from several government officials and central bankers, to the effect that the end of the recession is here and that the US economy is on track for recovery, does not explain recent USD weakness either. If this were the case dollar strengthening would be a more logical conclusion, as the Federal Reserve would be looking to start raising rates shortly. With rates rising, the dollar would look much more attractive from a yield perspective compared to the other 3 majors, GBP-JPY-EUR, and so would be strengthening rather than weakening.
Growing risk appetite
Rising stock markets have been a sign of decreasing risk aversion since March this year. The Volatility Index on the Chicago Board Option Exchange (VIX) fell from above 50 during the turmoil in financial markets at the beginning of 2009 to 23.69 recently. Together with this renewed risk appetite we see the carry trade returning again. In the past this trade was usually set up via low yielding currencies such as the JPY and or CHF, but right now the dollar is being used as the funding currency, with the investment being made in higher yielding currencies such as the Australian dollar or the New Zealand dollar.
This trade is only logically sustainable if the investor believes that the Federal Reserve will not be raising rates for the foreseeable future, as that would damage his/her funding play. This being the case, it automatically creates additional selling pressure in the forex market as dollar loans are sold and swapped into higher yielding currencies.
Trade balance and current account deficit
Current dollar weakness could be partially be explained by a US trade balance and current account deficit that is showing signs of widening again. The shrinking of both these deficits was actually a positive development for the US economy at the macro level, as it eroded a major global imbalance (and one that was a factor in the crash), but there are signs that this will be only a temporary development. The reduction of these deficits now appears to have been driven by the fall in import prices and the withdrawing of export credit and importers’ Letters of Credit, causing global trade came to a standstill. If the process now reverses, which seems likely, trade deficit growth will re-emerge and this creates more pressure on the dollar.
Conclusion
Contrary to some media comment, recent dollar weakness has not been due to inflation expectations (arising from rising US public sector debt and a Federal Reserve that is printing too much money). The return of the carry trade and a rising trade imbalance and current account deficit are much more viable explanations behind the continuing pressure on the dollar. Moreover I expect this to continue into 2010.
The writer is Head of Treasury, Europe Arab Bank, London
