FYI | Oct 24 2008
By Chris Shaw
At the same time as global equity prices have slid well beyond the standard 20% fall that defines a bear market, the US dollar has been moving exactly the opposite way. It has gained more than 17% against the British pound and the euro and 30% or more against emerging market currencies such as the Brazilian real and the South African rand in just the past three months.
As State Street Global markets points out, this reverses the long-term downtrend in the greenback, as from the start of 2002 until the currency bottomed in April it had lost almost 39% according to the DXY Index, which measures the US dollar against a basket of currencies. But in the months since April, it has recovered almost 20% of this decline.
The group suggests one possible reason for the reversal is safe haven buying, as the intensifying global financial crisis has seen investors run for the cover of what are regarded as the safest assets. With the US dollar being the global reserve currency it certainly fits the bill in that regard, as do US government bonds given the US bond market is the largest, most transparent and most liquid bond market in the world.
But with capital injections beginning to restore some life to interbank markets, is there are chance the US dollar buying will moderate, so reversing the US dollar’s recent upswing?
In State Street’s view the answer is no, for a number of reasons. Firstly, US investors are estimated to hold around 25% of non-US global market capitalisation in international equity holdings, which in dollar terms is worth something around US$5 trillion.
While the US market has not been great in recent months, it has performed ok in relative terms and so some of this money is being repatriated, meaning funds are again flowing into the US and therefore US dollars. As the group notes, such a trend reversal can continue for a sustained period if history is any guide.
As well, US investors have enjoyed gains from investing in overseas equities for many years, but with the upheaval in forex markets of late, these gains are being hit both by falling equity prices and a stronger US dollar. This means hedging may be considered by managers as they look to protect positions and in the group’s view, if such a strategy is introduced, it would be another minor positive for the dollar.
The other factor is global interest rates, as while the US has been aggressive in lowering its rates, the rate differential between the US and markets such as Europe and Asia should fall as other central banks and policymakers lower interest rates to deal with the weaker global economic outlook. This should also see some support in favour of the greenback against other currencies such as the euro and the British pound.
Institutional investors are pre-empting this by buying the US dollar aggressively, according to State Street, which it suggests means the renewed strength in the US dollar might in fact last for some time.
