Insufficient Underlying Support for the Dollar

June 17, 2011

When the dollar rises, demand has increasingly been driven by the fear of a euro break-up or some other development responsible for generalized risk aversion rather than improved confidence in the dollar itself.  The persistent correlation between dollar appreciation and increases in global risk aversion has moreover weakened lately.  In the period around the collapse of Lehman Brothers, the dollar snapped upward 30% against the euro between July 15, 2008 when the latter crested at 1.6038 and October 28, 2008 when it printed at $1.2331.  Risk aversion can also be measured by the decline in equity prices, oil prices and sovereign debt yields, each of which moved more sharply over the past month and a half than the euro-dollar relationship.  Changes in the following table are for the full month of May and for June as of 13:20 GMT today.

  May June
Dow Jones Index, % Change -1.8% -4.8%
Nasdaq, % Change -1.4% -7.4%
S&P-500, % Change -1.4% -5.7%
10Y Tsy Yield, bps -23 bps -10 bps
Oil, % Change -9.9% -8.8%
Dollar Against Euro, % Change +2.8% +0.7%

Net dollar gains were constrained this past week to 0.7% or less against the Swiss franc, euro, Canadian dollar, sterling, and yen.  The U.S. currency fell slightly against the Aussie dollar, which historically has been a good barometer of general risk aversion.  Compared to year-to-date averages, the dollar is merely 0.3% and 0.1% stronger against the Canadian dollar and sterling, and it now shows net declines of just 1.8% against the euro and 2.1% relative to the yen.  Greek debt is likely to be restructured eventually, but the latest developments on the matter suggest that a compromise to kick the day of reckoning down the road will be fashioned at this juncture.

Next week’s other main event will be the FOMC meeting and Bernanke press conference on Wednesday.  Investors are not expecting a third tranche of quantitative easing to be launched, and neither am I.  The Fed Chairman made pretty unsupportive remarks about the dollar at his first press conference on April 27 and is unlikely to go out of his way to correct any impressions of benign dollar neglect on this upcoming occasion.  He has spoken with much greater conviction about the urgency of devising a long-term fiscal plan and raising the debt ceiling before August 2nd, and those topics will no doubt be revisited and prioritized.  Through the lens of a struggling U.S. recovery and political animosity in Washington, little that Bernanke is apt to say will dissuade concern that the United States is on a path to a compromised standard of living and lessening geopolitical influence.

Even with the allure of safe U.S. capital markets, investors are hedging their exposure to a decline in America’s relative world ranking and a resulting further decline of the dollar.  One sees this in the composition of capital flows that tautologically must offset the U.S. current account deficit.  While the current account imbalance has lately been steady and, at 3.2% of GDP, well below the calendar year peak of 6.0% in 2006 and the 4.7% of GDP average over the ten years from 2000 through 2009, its relative size is still comparable to times in the 1970s, 1980s, and 1990s when bouts of dollar weakness were experienced.

The table below documents funding of the U.S. current account deficit in the first quarter of 2011 and each quarter of last year.  Official capital continued to counterbalance over half of the current account in the winter months of 2011.  Net private capital inflows including a negative $62.6 billion statistical discrepancy were similar in size last quarter to the prior quarter’s result.  That inflow of $52.6 billion masks a substantial deterioration in the longer-term components of U.S. net private capital inflow, namely the portfolio investment and direct investment.  In a healthy balance of payments, these flows ought to be comfortably in the black, but they instead swung adversely by over $135 billion from an inflow of $12.1 billion in 4Q10 to an outflow of $123.5 billion in the first quarter of 2011.  The deterioration over the two quarters between 3Q10 and 1Q11 amounted to $227.8 billion.

  1Q10 2Q10 3Q10 4Q10 1Q11
C/A -118.3 -120.3 -120.1 -112.2 -119.3
% of GDP -3.3 -3.3 -3.3 -3.0 -3.2
Official +98.4 +64.1 +135.2 +57.8 +66.7
Private +19.9 +56.2 -15.0 +54.4 +52.6
Dir & Port -15.5 +89.3 +104.3 +12.1 -123.5

 

A second table breaks down the combined change in private direct and portfolio investment between the final quarter of 2010 and the first quarter of 2011 in search of the causes of its big deterioration in the latest reported period.  The eight elements of long-term capital are U.S. direct investment abroad, foreign direct investment in the United States, U.S. buying of foreign bonds, U.S. purchases of foreign equities, foreign buying of Treasuries, foreign purchases of U.S. corporate bonds, foreign buying of U.S. agency bonds and foreign purchases of U.S. stocks.  The changes between 4Q10 and 1Q11 are shown in the right-most column below. A positively signed change indicates an increased net inflow, a reduced net outflow, or a swing from a net outflow to a net inflow.  The connection between these two tables is that the negative $135.7 billion sum of the right-most column’s figures in the second table equals the difference in direct and portfolio investment shown in the first table (minus 123.5 minus 12.1).

  4Q10 1Q11 Change
U.S. DI Abroad +93.0 +86.5 +6.5
Fgn DI in U.S. +70.6 +25.3 -45.3
U.S. + Foreign Bonds +14.7 +9.5 +5.2
U.S. + Fgn Stocks +28.7 +49.0 -20.3
Fgn + Treasuries +29.5 +3.5 -26.0
Fgn + U.S. Corporates +8.2 -4.6 -12.8
Fgn + U.S. Agencies +3.2 -36.6 -39.8
Fgn + U.S. Equities +37.1 +33.9 -3.2

 

One sees above a broadly-based turn for the worse in long-term U.S. capital inflows.  Foreign direct investment in the U.S. (such as the purchase of plant and equipment) fell by $45.3 billion.  U.S. residents invested $20.3 billion more in overseas equities than they had in the last quarter of 2010, and foreign demand for Treasuries, U.S. corporate bonds and U.S. agency bonds was collectively $78.6 billion smaller in 1Q11 than in 4Q10.  There were no large shifts to enhance U.S. private long-term capital inflows.  Note, too, that these shifts only involve only the private sector.  Reserve asset diversification by China, OPEC and other big dollar holders mostly involves official capital.  Together, an omnipresent extensive headwind against the U.S. currency exists in the background.  Such a negative can be outweighed in the short term by spikes in risk aversion whose timing is hard to anticipate.

Additional proof of the dollar’s long-term vulnerability comes from the irrepressible Swiss franc.  Since the beginning of floating rates, investors have turned to the Swissy in times when all paper currency is distrusted, so it is a natural hedge for investors who wish to limit their holdings of both dollars and euros.  The franc set highs of 0.8322 per dollar on June 7 and 1.1947 per euro yesterday.  Those levels constituted hefty gains of 41.0% and 24.7% for the Swissy from its 2010 lows.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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