Is something happening to the dollar? Something big and bad? Between the beginning of March and mid-May of this year, the US currency has declined just over 5% versus the euro. Not that noteworthy perhaps and the foreign exchanges have certainly seen much more drama than that in the past. And yet debate about the dollar’s prospects is hotting up. Is this just one of those temporary phases of dollar weakness that we have seen before, or instead, the start of something rather more emphatic?
According to HSBC’s currency team, the recent price action of the US currency is definitely unusual. “This (dollar weakness) seems to be not just a change in sentiment, but a change to the whole edifice of the dollar bull market – it is not the inalienable right of US assets to deliver superior rates of return,” they argue. During the dollar’s long bull run that started back in 1995, the dollar has tended to strengthen (in trade weighted terms) as US financial assets – both equities and bonds – have underperformed those both in Europe and Japan. From March of this year, for the first time in the current dollar bull-run since 1995, we have seen weaker US equity and bond markets and a weaker dollar.
HSBC conclude that the recent fall in the dollar is significant in that it is being driven by disappointment over the performance of US assets. “We believe the dollar has incorporated high expectations for US assets and those are not being met. If this disappointment continues, the dollar could come under sustained pressure.”
“Sooner or later the dollar will weaken against the euro, and this move may have already begun,” says Carnegie Asset Management’s Henning Hansen in Copenhagen. “The US has run huge deficits for years now and we believe that in the very long run (three to five years) the dollar should weaken to redress these imbalances. However, in the short run over the next year we think the dollar might retain its more positive tone.”
For Bruno Crastes, head of global bonds at Credit Agricole Asset Management in London, there are plenty of reasons to be bearish on the US dollar. “Historically, the dollar weakens as the economy moves from recession to growth; this action is a function of the very forward looking nature of the foreign exchange markets which, once the recovery has shown itself to be underway, start to discount future rate hikes.”
He adds “We do not like the dollar and think it will underperform globally. We believe that the dollar is fundamentally over-valued. Also we do not subscribe to the view that most investors are short the US dollar and so the dollar would find it hard to fall. Central banks, the big players, are hugely long dollars and have been for about three years. The US authorities have to have a strong dollar policy to maintain the world’s confidence in the currency because if they lose it then it could trigger huge moves out.”
World foreign exchange reserve holdings of dollars have grown sharply over the past seven years, almost doubling between the end of 1994 and the end of 2001 and was most concentrated in Japan and China. Analysis of the currency composition reveals that the proportion held in dollars rose dramatically. This not only reflects the fact that the dollar was strengthening over this time, but also indicates that central banks were reducing their use of the yen as a reserve currency and that the euro had failed to attract reserve holders.
“It has all been part of the process of balancing the US’s huge deficits,” argues Crastes. “Those central banks in countries with positive balance of payments have not been selling their dollars generated by their surpluses and some of these Asian central banks have seen their reserve holdings in dollars rise from 80% up to 90%.”
Crastes suggests that the dollar’s strengthening trend has been a friend to the Asian central banks and so they have not really had to worry that they have been holding so many dollars. “If Europe and the euro put aside their problems, then these central banks would find it very hard not to be buyers of the euro.”
Another theme that Crastes mentions relates to the state of corporate balance sheets. When there is very acute leverage of debt, the dollar has been strong, he argues, and between 1999 and 2000, European companies leveraged their domestic assets to fund purchases of US assets. And now, these companies are deleveraging, a process which Crastes suggests should be seen as another negative influence on the dollar.
It is hard to find dollar bulls at the moment but those few, and they are apparently in a small minority, brave enough to maintain their loyalty to the dollar were not quite brave enough to admit their views in public. For one group, 2002 will not be the year the dollar weakens. While acknowledging the lengthy list of dollar-negatives, they argue that the US dollar will be well supported by the US economy which, they forecast, will enjoy a strong and broad-based recovery.
Even they, however, acknowledge that the US dollar is over-valued, but think this is not an immediate impediment to further appreciation.
For the government bond markets, aside from the almost customary disdain for Japanese government bonds, there seems to be rather a lack of enthusiasm for anything. Says Carnegie’s Hansen: “Bonds might have a tough time in the near term, as short rates increase. But on a six to 12 month view we are not that worried about longer rates. We do not see that inflation will be that much of a problem. If we look at European inflation, for example, the recent ‘bad’ news can be largely explained by one-offs such as the oil price or weather-related food price hikes. And in the US we are still optimistic that inflation will not reappear even as the economy recovers – growth in US productivity will continue to keep inflation away.
“In the broad scheme of things, bonds are a sell because the economic recovery is the main theme which indicates amongst other things higher raw material costs, upward pressure on inflation and of course higher yields,” says Crastes. “However, the US yield curve is so steep which has meant that there have been lots of carry trades which have been very rewarding for the last six months.”
Crastes goes on to cite the huge number of carry trades, currently held in the US, as a relative negative for that market. “There is reward for hanging on as long as possible and riding down the curve as far as you can, but eventually you have to sell. We are marginally less negative on European government bonds right now because the curve is less steep and consequently there are far fewer carry trades waiting to be unwound. In this bearish environment we think that European bonds will outperform.”
Hansen and his colleagues agree that short rates will rise but are confident that longer yields are safe where they are, suggesting that yield curves will flatten in the coming months. Within their benign forecasts for European bonds, Carnegie point to Sweden as having the fairest outlook. “Financial assets in Sweden have been badly hit by the well-publicised problems in the telecoms’ sector,” explains Hansen. “We all know that Sweden’s markets are dominated by the telecoms and that there has been a stream of bad news for months. International investors have been selling their Swedish assets and getting out of the Swedish krone too. Add to this selling further sales from domestic investors and it is not hard to see why the currency has fallen.
“But, if you look at the fundamentals, they point to a stronger currency. We think Sweden will change its attitude to European Monetary Union and we believe it is a good convergence play.”