Dollar
Robust dollar signals switch of focus
By Peter Garnham
Published: February 11 2008 22:16 | Last updated: February 11 2008 22:16
The dollars resilience in the wake of recent dire US economic data has raised the prospect that the currency market may be experiencing one of its periodic changes in focus.
Analysts say currency investors could be eschewing their long-held chase for yield and instead looking through the current slowdown to reward currencies with the best prospects for growth.
This held true as the Federal Reserve started cutting interest rates in the second half of last year, sending the dollar down to a record low of $1.4968 against the euro in November.
However, the dollar has held up against its major trading partners over the past three months in spite of a string of bad news suggesting that the US economy could be heading into recession.
Even the 125 basis-point cut in the Fed funds rate over the last month has not forced the dollar beyond last years lows. Last week, the dollar put in its best performance against the European single currency for 18 months.
Analysts say the counter-intuitive strength of the dollar is a warning that the drivers of the foreign exchange market may be changing.
The market does not seem to be driven at the moment by interest rate differentials, which would point to a weaker US dollar, says Marc Chandler at Brown Brothers Harriman.
He also says the foreign exchange market no longer seems so closely correlated to the equity market
At the start of the global equity market correction in November, rising risk aversion boosted the low-yielding yen and Swiss franc as investors liquidated carry trades, in which the purchase of riskier, higher-yielding assets is funded by selling the low-yielding currencies.
But the yen and the Swiss franc lost ground against the dollar last week in spite of a sharp sell-off in global equities.
Mr Chandler says it is possible that the focus of the currency markets will shift towards economic growth.
With the nearly unprecedented pace of US monetary easing and fiscal stimulus, more observers seem to be be coming around to our view of a short and shallow economic landing in the US rather than a long and deep downturn and this is supportive of the dollar, he says.
In effect, the dollars gains may reflect the market looking past the landing and toward recovery in the second half of this year.
Much of the dollars weakness last year reflected speculation that countries outside the US would be insulated from a slowdown in the worlds largest economy so-called decoupling.
However, David Bloom at HSBC says that as the US slowdown intensifies, it is becoming hard to be confident that it will not spill over into other economies.
He says the performance of the Canadian dollar, with its close ties to the US, can be viewed as a good proxy for the decoupling thesis and shows the market has been testing the theory.
The Canadian dollar has dropped nearly 9 per cent against its US counterpart over the past three months, making it the worst performing major currency.
The Canadian dollars weakness suggests investors believe the decoupling view was excessive, Mr Bloom says.
Similarly, the pound has been punished, dropping more than 6 per cent against the dollar over the past three months amid growing fears that turbulence on the world asset markets could spill over into the UK economy, which is heavily reliant on the financial sector.
Meanwhile, recent data from the eurozone have indicated a sharp slowdown since the start of the year, prompting fears that the European Central Bank may not be reacting quickly enough to negative economic developments, which in turn could damage the euro.
In contrast to the aggressive interest rate cuts in the US and more modest monetary easing in the UK and Canada the ECB has just backed down from its bias towards raising interest rates, last week citing fears over downside risks to growth from a slow- down in its large trading partners.
Gavin Friend at Commerzbank says increased pessimism over global growth will further highlight the contrast in the approach to the US-led global economic downturn between the US authorities and those elsewhere.
He says the markets remain in the dark over the depth and duration of the slowdown, but are responding to the aggressive US monetary stimulus by buying the dollar.
It is not only that, in the minds of many, the US is far out ahead of other monetary authorities in attempting to tackle the slowdown, he says.
But also because of the aggressiveness of the action itself, which is prompting thoughts of it really must be bad, fuelling spill-over fears.
Analysts say the fact that most central banks are expected to follow the Fed in cutting rates will have implications not only for normal investment flows but also for central bank reserve diversification away from the dollar.
The diversification of the vast foreign exchange reserves of Asian central banks, particularly China, away from the dollar has exerted downward pressure on the greenback in recent years.
However, Geoffrey Yu at UBS says reports last week that Chinas new sovereign wealth fund is planning to inject capital into JC Flowers, the US private equity firm, with the aim of investing in distressed financial institutions may add to the belief that the trend is reversing.
This is another sign that well-funded reserves are opting to remain with the dollar and take advantage of depressed valuation with strong growth potential, in addition to favourable exchange rates, he says.
The US remains the key target for such investment flows and a strengthening of such trends will aid the dollar in its recovery.
Copyright The Financial Times Limited 2008