Currencies | Nov 26 2009
By Andrew Nelson
The Fed’s commitment to keep interest rates at low levels for the foreseeable future shouldn’t be underestimated in terms of what it will do to the US dollar, economists suggest. The central bank’s stance will almost certainly keep heavy downward pressure on the greenback in the near-term and over the long months ahead.
Once upon a time, a positive direction in the US economy and strength in the nation’s stock market were generally accepted as being supportive for the US dollar. Yet US two-year bond yields are just a few basis points above the levels of last December’s middle of the financial crisis lows despite the US economy technically exiting its recession and equities markets rallying more than 65% from their March 2009 lows.
However, there are several other factors that Commonwealth chief currency strategist Richard Grace notes as being ultimately responsible for the weak yields aside from the Fed’s commitment to keep interest rates low.
First, he points out that there is a large amount of spare capacity in the US economy and a very low level of inflationary pressure. There is also still a large amount of cash in the US that is determined to sit in a perceived safe-haven.
Lastly, many in the market are looking to ride the US yield curve by borrowing at the short end of the curve and putting the money into longer term positions.
As such, the front end of the US yield curve is now trading well below equivalent rates in Japan. Grace notes that portfolio data suggests that the US has been unable to fund its current account deficit for 9 out of the last 10 months. This means the US dollar has to fall to compensate for the low yields in order to allow the US to fund its current account deficit.
This all leads Grace to predict that the USD will continue to decline as long as inflationary pressure remains low and as long as net portfolio inflows remain insufficient to fund the US account deficit.
For things to turn, Grace believes that there will need to a rate hike on the back of increasing inflationary pressure. That, or a serious revival in risk aversion on the back of a double dip recession in the US economy, which would conversely increase the greenback’s appeal as a safe-haven position.
However, once the greenback turns, the move will be sharp, predicts Grace, given the currency’s new found position in carry trades.
