Brave New World

New Funding Currencies I: The Dollar 17/09/2009

Much has been made over the last week of a perceived sea change in the currency markets, particularly with regard to the USD. Many currencies are now yield little, if anything, more than the Japanese Yen, a currency used to fund investments in higher yielding currencies- the carry trade. With a pick up in global pick up in economic activity and large amounts of liquidity in the US bond market, investors are resuming the search for yield.

Following the Lehman Brothers turmoil in the last three months of 2009 most analysis of the movement of the USD relative to most other G10 currencies has been focused on risk appetite. The US dollar has had an inverse relationship with the global level of risk appetite. To be sure, it is not alone among G10 currencies in this regard. The Swiss Franc has had a long-standing historical role as a safe haven currency and has performed as expected in the current crisis; enough to lead to the SNB being the only bank in the G10 to directly intervene to prevent further appreciation against the EUR. Similarly, the Japanese Yen strengthened, as interest rate differentials were deemed increasingly irrelevant in a period of heightened volatility. However, against the traditional high yielders- the EUR, GBP, the Scandis and the Commodity currencies, the USD showed considerable strength in the first half of 2009. This was despite worries over the potential inflationary consequences of the fiscal and monetary stimulus and murmurings by Chinese and Russian officials regarding the position of the Dollar’s reserve status.

Well, the USD looks like it’s being routed. A strong rebound in the global economy and a succession of positive economic data from the US has led to greater confidence among investors and a greater appetite for risk. The safe haven status of the US Dollar looks less attractive and so a sell off has ensued. Moreover, the domestic bond market is awash with liquidity with the yield on a two year Treasury- with little sign that the Fed is likely to turn off the taps soon. A cautious attitude prevails among central bankers that the rebound in GDP is on firm footing. The recent G20 meeting of finance ministers in London appeared to confirmed that policymakers are unlikely to exit in the near term. So, with a combination of strong economic growth now being found in many places around the world and US interests at historical lows there is little reason to hold the USD. Indeed, the USD may be turning into a funding currency, the role played by the Yen over the last decade. Similarities between the JPY and the Dollar (plus Sterling) are increasing. Bank of New York in their Daily FX briefing said:

This is  that for the first time in modern financial history, the 3-month offer rates for both the USD and GBP (and, in fairness, the EUR as well) have fallen to the levels that characterised the JPY throughout the period that it became used as a funding currency for carry trade activity. As of this morning the USD 3-month offer rate comes in just above50 bp while that for GBP stands a little above 60 bp.

The US economy is recovering and should post positive economic growth by the end of the year. However, that would simply not have been achieved without the unprecedented amounts of fiscal and monetary stimulus enacted earlier this year. Fiscal tightening will almost certainly start to take place next year, and so it will be left to the Fed to support a still weak economy. Rate hikes are not expected soon, and with it the US may begin to experience a very similar situation faced by the Japanese in the middle part of this decade; that of funding the carry trade. Not exactly a pillar of financial stability.