Don't short dollar on grounds risk appetites are
By Brendan Brown
May 2009:- According to one now popular line of analysis, the dollar is falling because global risk-appetites are increasing.
The idea is that the dollar's strength during the 2008 Financial Panic was attributable to a surge in demand for safe-haven currencies. Now that demand is evaporating, the dollar is weakening. This line of argument is treacherous, as are several other lines of risk analysis now enjoying some media-coverage.
The dollar's strength in late 2008 was certainly part related to the Panic. But most of all it reflected the pull-back of capital from Europe (and East Asia) by US money market funds and the inability of many borrowers to refinance in dollars. This was due to the break-down of currency swap markets, which forced borrowers to buy the US currency in the spot markets with the proceeds of domestic borrowing (often from the respective central bank).
The end of the panic has meant that the bid for US dollars began to
vanish early this year.
As regards the decrease in risk appetites late 2008, that in principle should have had a big influence on the yen, given its key role in the carry trade i.e. borrowing low interest yen to buy high yield currencies such as British pounds, Korean won, East European currencies, Australian dollars and foreign stocks etc. Indeed the yen reached its peak during the Panic, with the recipient currencies in the carry trade then reaching their trough. Now that risk appetites are apparently increasing, as illustrated by the re-bound of global equity markets, it is reasonable that the yen should fall back and the carry trade recipient currencies rise.
As regards the dollar, it is not clear that risk appetite (as against
panic shut-down of international lending) plays a role in value either
on the way up or down. In any case shift in risk appetite is only one of several key factors influencing valuation of any asset class. Don't forget the fundamental appraisal of income prospects! Yes, an increase in risk appetite on its own should mean the yen falls and the pound rises. But if at the same
time the outlook improves for the Japanese economy in the long-run,
especially regarding the creation of investment opportunity and the degree of competitiveness, then the yen would recover again.
The very recent up-tick of the yen from around 100 to 96 against the dollar, despite increasing risk-appetites, may indeed by symptomatic of just such change in perceptions. Perhaps the crisis in Detroit is raising the likelihood of Japanese automakers gaining long-run market share in the US; perhaps the recovery in the Chinese economy is particularly positive for Japan. Perhaps demand for Tokyo equities has been rising apparently based on such consideration; and perhaps Japan is well-placed to gain competitive advantage as the US economy grapples over the medium-term towards a new equilibrium growth path characterised by higher business investment and less consumption than in the past decade.
The US dollar's fall-back against the European currencies could reflect
anxiety about a potential US inflation shock in 2011-12. The markets may
be speculating that though the Bundesbank lost the first battle at the ECB over quantitative easing, it will now impose an effective veto on any further moves in that direction. All of this remains conjecture at this point - as do the looming geo-political dangers which might indeed spur a surge in demand for US dollars later this year (Iran, Pakistan, Russia).
Brendan Brown is London based head of research at Mitsubishi UFJ Securities International
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