The Dollar As A Funding Currency

Nouriel Roubini is not a man who is known for mincing his words. “We have the mother of all carry trades,” he tells us, “Everybody’s playing the same game and this game is becoming dangerous.” There is a “wall of liquidity” sweeping the planet, pushing asset prices ever higher in one country after another. I wholeheartedly agree.

Investors across the globe are taking advantage of the ultra low interest rates on offer at the US Federal Reserve to borrow in dollars in order to buy assets like government debt, equities and commodities, in the process, as Nouriel says, fueling “substantial” booms that if not checked in time may sow the seeds of yet another financial crisis. This is a classic example of the so called “carry trade” in which investors borrow in countries with low interest rates to invest in higher-yielding assets.

The dollar has fallen by about 12 percent (in relation to a basket of six major currencies) in the last year as the Federal Reserve has cut interest rates to a record low of around zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. The problem is that this has created what Professor Roubini rightly terms the mother of all carry bets against the US dollar, and lead to all kinds of speculation that we are at the dawn of a new era, one which will have the “death of the dollar” as its defining characteristic, and where in the dollar will no longer serve as the world’s reserve currency of preference.

Well, as someone once said, rumours of my imminent demise are somewhat exaggerated. The greenback is still alive and kicking, and will be for many years to come, although we also need to be realise that structural changes are underway. So while in the short term we should not really be in doubt that the decline in the dollar will eventually “bottom out” as the Euro-USD crossover reaches ever more painful levels for the eurozone’s heavily export dependent economies while the Fed will at some point begin to hint that it is considering raising borrowing costs and start to with draw some of the “quantitative easing type” stimulus measures, including, of course, those large scale purchases of US government debt. But this is not likely to happen rapidly, or in a disorderly fashion, so in many ways investors will have time and space to reorganise their betting card.

This was once more made plain this week, when Federal Reserve decision makers signaled quite clearly that a simple return to economic growth alone won’t justify higher interest rates on their part, stressing that any future increase will depend on the labour market and inflation trends, and indeed the Fed’s rate-setting Open Market Committee resasserted its pledge to keep rates “exceptionally low” for an “extended period.” Following these comments traders began to pare back their bets that an increase in borrowing costs will come in the first half of 2010, the dollar weakened and short-term Treasury yields fell.

The impression that the Fed will not be the first out of the box among the major central banks was only reinforced today as the European Central Bank seems to have hesitatingly taken its first step toward removing emergency stimulus measures by indicating it won’t be continuing to provide commercial banks (and of course the governments whose debt they are buying) with the current 12-month loans as 2010 advances - although no timetable for phasing them out has so far been provided. Nor has it been made plain what structure will replace them. Jean Claude Trichet seems to have contented himself with enigmatically teasing the assembled journalists by stating “Not all our liquidity measures will be needed to the same extent as in the past” and pointing out that since market sentiment didn’t expect the ECB to prolong its offer of 12-month long term funding beyond December he was going to “say nothing to dispel this present sentiment.”

Assessing what exactly is happening here is difficult, since in the world of central bankspeak it would be a mistake to think that expressions mean what they actually normally mean in everyday discourse. So it is not clear whether or not the strategy between the Fed and the ECB is coordinated at this point or not, and if it is, to what extent. Certainly despite Timothy Geithners insistence on the US Treasury's strong dollar policy, it is hard to imagine that anyone (not even the Chinese) actually take him at face value here, and indeed, if you read the reports carefully, Trichet is only complaining about excessive volatility, and not about the level of the Euro in and of itself. This impression, that those taking decisions accept that the dollar needs to stay down to allow the US economy to correct itself is only reiforced further by concerns expressed only today by Kenneth Rogoff, Raghuram Rajan and Simon Johnson (all economists who have previously worked for the IMF) as to whether the IMF and the G20 actually had the wherewithal to address the global imbalances problem. It should not escape our notice that this "concern" was expressed just one day before G-20 finance ministers and central bankers, including U.S. Treasury Secretary Timothy Geithner and European Central Bank President Jean-Claude Trichet, are to start two days of talks in St. Andrews, Scotland.

In fact, there is some evidence of progress being made, since the U.S. current account deficit narrowed in the second quarter to its lowest since 2001, and I'm pretty sure a solid majority of Europe's leaders accept the need for the deficit to be allowed to correct further if future growth is to be put on a more solid footing.

This having been said, however, it is not at all clear how the issue of weaning the banks of the one year funding is going to be conducted, especially in a year where most European governments are going to have very large borrowing requirements indeed. Again, Trichet was at pains to stress the need for the Commission to police the Stability and Growth Pact effectively, even allowing himself to go so far as to say that a 0.5% point annual reduction of the structural deficit after 2011 simply wasn't sufficient. But, when push comes to shove, it is hard to see the ECB willingly precipitating a financial crisis in a major eurozone country - like for example Spain. According to the latest EU Commission forecast, Spain will have deficits of 11.2% of GDP this year, 10.1% of GDP in 2010 and 9.3% of GDP in 2011, and even in 2011 they do not expect the Spanish economy to grow by more than 1% (optimistic even this on my view), while they still expect the unemployment rate to be running at 20.5%.

As can be seen in the chart below, a very large part of the recent borrowing by the Spanish government to fund this years deficit has been financed by issuing short term bonds.

And at the same time the dependence of Spain's banks (who have in one way or another acquired many of the short term securities) on the one year funding has been considerable (see chart below).

And so of course in 2010 much of this debt will need to be "rolled over" and next years deficit will need to be financed as well, and it is almost impossible to see how this can be achieved without inflating the spread again (which has been brought down considerably of late) unless the ECB lends a willing hand.

Of course, what Nouriel Roubini is worried about is none of this, since he isprincipally concerned about how a future seismic shift in the perception of the dollar may force investors to reverse the existing carry trades and how this may produce a further mini financial crisis as there is “rush to the exit”. Evidently there are precedents here, since the rapid unwinding of the Japanese carry trade last autumn only added to the general feeling of financial chaos following the collapse of Lehmann Brothers.

So what are the risks of a repeat performance on this occassion? We, the risks are certainly there, but perhaps we have the key to understanding why the Japanese carry trade unwinded so violently is to be found in the last paragraph, since the Yen carry went west so quickly due to a decline in risk sentiment, and the safe-haven surge in both the Yen and the USD was a response to this decline in sentiment, and not its cause. Yet presumeably, and at least in the short term, any move by Ben Bernanke to raise Federal Reserve interest rates would be a signal for a further rise in risk sentiment, and not a response to a decline, and as such it should in theory trigger another surge in carry appetite, and not its dissapearance. Unless, of course, the dollar rise was precipitated not by the Fed's rate tightening programme, but by perceived risk elements in the "other" currency in one of the pairs - that is the euro. Personally, I consider the situation in Spain to be much less of a "side-dish" in the current financial crisis than many seem to feel it is, and indeed I would take Spain as the largest and potentially most dangerous of the loose cannon we have floating about on deck as we try to steer our way forward and away from the storms.

Not that the announcement of a future tightening in monetary policy in the United States (which would presumeably be underwritten by a series of positive and glowing reports that the US economy was finally and without a shadow of double-dip doubt emerging from its deepest recession since WWII, that its to say it won’t be coming soon) would not present technical issues about the future dynamics of carry – closing USD positions only to reopen them in Yen, Swiss Francs, or (why not) even Euros if despite Trichet's optimism today Europe’s economies prove unable to stage an early exit from recession. It would still be carry on up the Khyber time whichever way you look at it.

But lets go through some of this step by step.

The Dollars Fall – Cyclical or Structural?

As noted above, the USD has particularly weak in 2009, falling by 15% on a trade-weighted basis since in had a local peak in March. March it will be remembered is not a coincidental date, since many emerging markets stated to climb precisely in that month (see Brazil MSCI Chart).

But as I am also suggesting the dollar’s recent fall is more cyclical than structural. The massive injection of liquidity by central banks has created an environment which is favourable to equity and commodities markets in some key emerging economies, together with the associated commodity and emerging currencies, and since the depth and accessability of the US markets is evident, then much of the associated trade has been taking place at the expense of the greenback.

The dollar’s recent decline has been accompanied by repeated forecasts of its terminal demise, accompanied by ever louder calls for the creation of an alternative reserve currency. However, I personally believe that the current fall in USD is more temporary than permanent, and that the structural factors often cited as the raison d’être for the dollar’s decline have – so far - played only a limited role. Which is not to say that these factors won’t come into play at some point, and hence we are in the mother of all complex situations – but it is just, as I said, that news of its imminent demise is rather premature and greatly overstated.

Much of the brouhaha from the structural dollar bears has of course been associated with the issue of the sustainability of the US fiscal deficit, and although, of course, the current double-digit U.S. government budget deficit is extraordinarily large in historical terms, it is nonetheless comparable to those being sustained in a number of other major economies (Japan, the UK, Spain, etc). At the same time there is still little significant evidence of foreigners becoming totally disenchanted with buying US debt – in fact on aggregate (including both the private sector and central banks) they are still busy buying Treasury bills and bonds, even if at a rather reduced pace ($287B in the past six months compared to $490B in the second half of 2008). Indeed, the most recently available figures (oh Brad Setser, wherefore art thou?) do point to a fall in the proportion of the world’s FX reserves held in US dollars, but this fall in my view is prudent and cyclical (due to the dynamics of the dollar decline) and fairly likely to reverse as and when the the dollar turns. And it should be remembered US households are now saving at a much faster rate than they were – so the domestic market for US government debt is proportionately greater. In addition gross government debt levels for the overall U.S. public sector are not that different from those to be found in comparable countries like the U.K. and Germany (as a % of GDP), and well below those to be found in countries like Italy and Japan. Which doesn’t mean to say that the US hasn’t got a long term structural debt problem associated with the liabilies entailed by population ageing, it is just if that anyone is going to be the first to go bump in the night, then Japan or Italy are the obvious candidates.

At the same time (and as I already argued here some months ago – see my summary of the Krugman/Ferguson debate here) there is little serious risk of runaway inflation undermining the dollar (or indeed any other major currency) in the short term. We are not all Zimbabwe on toast (yet awhile) – and those who suggested this as an imminent short term possibility got something, somewhere, seriously wrong. And the reason is not hard to fathom, since - as can be seen in the accompanying chart – despite the massive increase in base money, growth in the broader monetary aggregates remains severely constrained. Narrow money growth across the OECD has accelerated significantly in recent months, reaching 12.9% year on year in August (see chart below).

In large part the acceleration in base money reflects the very stimulative monetary and liquidity stance adopted by the major central banks across the globe - the Federal Reserve, the Bank of England, the Bank of Japan, the European Central Bank, etc. In contrast, growth in broader money measures has actually slowed significantly in recent months, to just 6% year on year for the OECD by August 2009. Such broad money aggregates differ from base money in that they reflect not only the actions of central banks, but also those of commercial banks and other financial institutions operating within the broader economy. The fact that broad money growth is slowing even as narrow money measures accelerate suggests that the cash injected by central banks into the banking system and money markets is not circulating around the economy as one might typically expect.

Put another way that so called “high powered” money simply isn’t what it used to be, and certainly isn’t packing either “heat” or sufficient clout.

And again the explanation for this is clear enough, since the global financial shock has left capacity utilization rates at a very low level while rising jobless rates restrain cost pressures, at least in the near-term. So while the issue of the inflation impact of all this over the longer term is still an open question, at least in the short run we are alive, but we are not yet kicking. But one day we will be, and since it is extraordinarliy unlikely the world’s central banks will knowingly allow inflation to become entrenched over the medium to longer-term, all attention know is focused on the exit strategy dynamics.

What has evidently surprised many market participants and observers is just how much of this ‘new’ liquidity appears to be finding its way into emerging market assets. Emerging market government bond spreads vis a vis U.S. Treasuries have now narrowed to around 300bp (from around 865bp at the peak of the crisis), the CRB commodities prices are up 40% from their low, while global equities markets have surged 55% from their low point – a much stronger rebound than might have been considered consistent with current or prospective global GDP growth. Ben Bernanke and his Federal Reserve colleagues have, it seems, been pumping liquidity in through one door, only to seek it “leak out” through another.

And all the tell tale signs are there is we look at which currencies have in fact benefited - at the expense of the U.S. dollar – from the surge in liquidity. The commodity sensitive Australian and New Zealand dollar are both up around 30% year-todate, and have started to close in on pre-crisis peaks. Among the emerging markets, the Brazilian real (34%), and the South African rand (26%) have enjoyed particularly large year-to-date gains. 2009 has also been characterized by an especially prominent correlation between stronger equity markets and a weaker dollar as funds have been diverted towards these asset markets. The MSCI World Index of advanced-nation equities has surged 65 percent from this year’s low on March 9, while the MSCI Emerging Markets Index has jumped 96 percent. The Reuters/Jefferies CRB Index of 19 commodities has added 33 percent.

This relationship between global liquidity, global asset markets and the U.S. dollar is likely to remain a key theme for the foreign exchange market during 2010. However, as we move further away from the peak of the global financial crisis and the trough of the global economic recession, central banks (and governments) will start to remove some of the stimulative policy measures put in place over the past couple of years. This policy tightening is not necessarily designed to restrain growth or head-off inflation, but rather to remove ‘emergency’ measures that are no longer appropriate as financial markets show some stabilization, and as economies show a return to growth. The trend towards less policy accommodation has only just begun with a rates hike from Australia earlier this month and from Norway only last week. But the looming question is who, among the G7 central banks will be the first to be able to raise, or threaten to raise, or even start to take off the emergency liquidity and fiscal measures, and in which order will this be done. In any event, despite the suggestive hints from Jean Claude Trichet at the latest ECB rate meeting my expectation is still that the US Fed will be the first to take serious steps, and at that stage we should expect, as I say at the start, the epicentre of the global carry trade to shift yet one more time from New York to Tokyo, but the show will be far from over, and in some ways it may well be only just begining.

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