from Follow the Money

The dollar, still a currency that you run to?

August 16, 2007

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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There clearly has been a flight to liquidity recently.  T-bill yields have collapsed (See the Econocator).   Perhaps because of the Fed.  Perhaps because folks are hoarding cash and nothing that pays interest is as close to cash as a T-bill.

And a rather significant unwinding of the carry trade.   The Icelandic krona has fallen by more than 15% against the yen.   The Kiwi has also sold off.   Ms. Watanabe didn’t step up to dampen this bout of volatility … 

The yen has rallied.  Significantly.  That makes sense.  It was a big funding currency.   And if credit is no longer going to be quite as readily available to finance deficits, the currencies of countries with current account surpluses are – one assumes – safer than the currencies of countries with large deficits.

Most big deficit country currencies are falling: the Australian dollar, the British pound, the Turkish lira as well as the Icelandic krona and the New Zealand dollar. 

But the currency of one deficit country – the United States dollar -- also rallied.  

No matter that that the origins of this particular crisis are clearly in the US – and in the one area of the finance (turning subprime mortgages into triple AAA credit through financial engineering) where the US unambiguously had a comparative advantage.    A couple of weeks ago the IMF even argued – in its summary of the staff papers that accompanied the Article IV -- that the United States’ unique ability to create complicated financial structures would continue to pull funds into the US, and thus help finance the US current account deficit. 

“Many industrial countries still have much to gain from further international diversification.  Combined with innovative US fixed income markets providing many assets that simply are not available elsewhere this suggests … that a significant fraction of industrialized countries funds …will be directed toward US fixed income assets.”

Oops. 

Can a bout of global risk aversion that has made much of the "innovative" US fixed income market illiquid really provide more support for the dollar than demand for US financial engineering ever did?  Bloomberg reports that is could

“``This is where people take refuge,'' said Komal Sri-Kumar, who oversees $145 billion as chief global strategist at TCW Asset Management Co. in Los Angeles. ``The dollar is still a safe-haven currency.''

Talk about a Teflon currency. 

Can in it be that a credit crisis in the US is actually good for the dollar?   In good times, the world clamors to buy US financial alchemy.   And in bad times the world clamors to buy US treasuries.   No matter what, the US deficit is financed. 

The dollar, along with the yen and swiss franc, seems to have been a popular funding currency.    That means folks borrowed dollars to finance their investment in high-yielding currencies like the Brazilian real and Turkish lira, betting that the dollar would fall against these currencies.   John Authers:

Then there is speculation. Marc Chandler, strategist at Brown Brothers Harriman, says the dollar, like the yen and the Swiss franc, has become a “funding currency”: traders sell the dollar short, and use the profits generated as it falls to invest elsewhere. As they lose on those other investments, they remove their “short” positions – or, in English, buy dollars

And right now all funding currencies are rallying, and all destination currencies are falling – even the currency of a country like Brazil that doesn’t have a current account deficit.  The real is down by something like 4% today ....

The US dollar though is a strange funding currency.   The US after all, needs big capital inflows to finance its current account deficit.   The US consequently differs from Japan and Switzerland, countries that save more than they invest and thus have funds to lend to the rest of the world.  US investors could only borrow dollars to invest in say Turkey because foreign investors were putting more funds into the US than the US needed to finance its current account deficit, leaving some money left over to finance US investment abroad. 

There are presumably two other reasons for the dollars recent rally.

US investors with profits on equity investment abroad are selling those investments to raise cash, and in the process buying dollars.  Everyone wants a bit more liquidity.  John Authers, again.

The retreat from risk is more important than fundamentals. US investors have invested heavily outside the US. Faced with subprime losses, they have taken profits. The net effect is to buy dollars.

It turns out that a lot of “European” demand for long-term US corporate debt was financed in the US money markets.   European – and some US – financial institutions set up “conduits” and structured investment vehicles to borrow short-term in dollars in the US money market and buy long-term US debt, often repackaged mortgages and the like.    Now I would bet some institutions that cannot access the US commercial paper market are borrowing in euros and then selling their euros and Canadian dollars to buy US dollars.  

The ECB injected awful lot of liquidity into the market after a couple of European institutions got into trouble … .  

But over time, well, the US still will have a big deficit to finance.   The US economy seems more likely to slow than to accelerate, but the slowdown won’t reduce the US deficit all that quickly (especially if interest payments rise).   The ECB seems more likely to rise than to hold, while the Fed may cut.  Interest rate differentials should shrink.

Private inflows were not large enough, in net, to finance that deficit even when there was a lot of appetite for financial engineering.    The world’s central banks will no doubt continue to help the US out.   But they too would rather not have all their eggs in one basket – 

And then, as Barclays notes, European and others have been big buyers of US equities – and if the US slows and there is a general flight away from risk, then US money coming home should be matched for European money coming home.

“Foreign investors are also likely to trim their holdings of US equities in this situation and the fact is they have bought as much US equities as US investors have bought foreign equities since the global equity markets began to recover in 2004. Is there any reason to think American investors will bring money home faster than foreign investors will reduce their holdings US equities? At least in recent history, there has been no such example.” 

Count me among the skeptics that bad news in the US is good news for the dollar – at least over a longer-time horizon.  Like Goldman, Merrill and Barclays, I would expect that problems in the US credit market will reduce foreign demand for US corporate debt, and thus for US dollars.  That -- particularly in conjunction with slow US growth -- likely means ongoing dollar weakness and ever greater reliance on central bank financing ...

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