Investors Wary of Post-QE2 Bear Trap for Dollar (FT 26/5/11)
Dollar bears are getting nervous. Only a few weeks ago, the US currency was sliding towards record lows. It has since rebounded, a move some believe could herald a sustained recovery as the Federal Reserve pulls the plug on the cheap money it has pumped into financial markets.
Many investors remain short dollars, especially against Asian and commodity-linked currencies. But dollar bears are trimming positions before the end of June, when the Fed ends its second round of quantitative easing, dubbed “QE2”.
Since the Fed began buying bonds – its aim being to bring down borrowing costs and breathe life into the US recovery – the dollar has declined significantly. The effect was to flood the banking system with free reserves. Thus the dollar became an attractive way to fund “carry trades”, in which low-yielding currencies are sold to finance the purchase of higher-yielding assets such as equities, commodities and commodity-linked currencies.
The stock of money in the US has tripled from $844bn in August 2008, before the start of the Fed’s first round of quantitative easing, to more than $2,390bn.
“Currency dilution, perhaps more than any other single factor, has provided speculators with a convincing reason to sell the dollar on the global foreign exchange market,” says Michael Thompson, head of valuation and risk strategy at Standard & Poor’s.
Caught short? Dollar long and short positions “In our opinion, the conclusion of QE2 removes a great deal of the fundamental pressure that has been weighing on the dollar in recent years.”
Mr Thompson says this could trigger a wave of short covering as investors buy back the dollars they sold, a phenomenon that can signal the bottom of a downtrend. There are signs that this process is already under way.
Data from the Chicago Mercantile Exchange, often used as a proxy for hedge fund activity, show speculators reduced the value of their bets against the dollar by $8bn to $25.5bn in the week to May 17. This means bets against the dollar were at their lowest since January and down from record levels this month.
It is not just hedge funds that have been trimming their bets against the dollar. Mansoor Mohi-uddin, managing director of foreign exchange strategy at UBS, says money managers such as pension funds have also been reducing their positions in recent weeks.
This has been reflected in the price action on global currency markets. The dollar index, which tracks its progress against a basket of six leading currencies, has rallied nearly 5 per cent since hitting a 33-month low of 72.696 on May 4 and currently stands at 76.077.
The minutes of the Fed’s last policy meeting provided the trigger for the rebound. They laid out principles to guide monetary policy in the future, while assuring the market that QE2 would, as planned, stop at the end of this quarter.
Mr Mohi-uddin says that has prompted investors to consider not only the end of QE2, but also the Fed’s next steps to tighten monetary policy. These could include ceasing to reinvest the Fed’s maturing assets back into bond markets, the dropping of the phrase “extended period” of considerably low interest rates in the Fed’s policy statement and the first actual rise in the Fed’s main lending rate.
“This matters because currency markets continue to price in Fed policy staying super loose for the foreseeable future while other foreign central banks start to raise rates,” he says.
“The Fed’s latest communications show that the currency market is mistaken in assuming the Fed to be super-loose indefinitely.”
Mr Mohi-uddin believes the dollar has room to rally as the Fed’s resolution to end QE2 lessens demand for carry trades and improves the confidence of Asian central banks and reserve managers in the US currency.
Other factors have been pushing the dollar higher. The eurozone debt crisis and fears over global growth have been supportive, with investors drawn to the US currency and other havens such as Treasuries and the Swiss franc.
Lee Hardman, forex strategist at Bank of Tokyo-Mitsubishi UFJ, says the wrangling over legislation to raise the US debt ceiling was unnerving investors. “In these circumstances, the safe haven currencies of the dollar, Swiss franc and yen are likely to extend their outperformance in the coming months,” he says.
But, given the impasse over the US Treasury’s borrowing limit, not everyone is so upbeat on the dollar. If Congress does not act to increase the debt ceiling by early August, the US faces the theoretical prospect of defaulting on its debt.
Axel Merk, president and chief investment officer of Merk Investments, says irreparable harm may have been done to the dollar and its reserve status.
At the moment, the US government may roll over existing debt, but cannot issue new debt, he says. This has created a situation where fear may spread that there simply will not be a large enough supply of debt to meet investor demand.
Mr Merk’s concern is that the growing scarcity of Treasuries will force foreign central banks to deploy reserves outside the US government bond market.
“As foreign central banks gain operational experience in less liquid markets, they may not revert back to US Treasuries once the gridlock in Congress is resolved. They may accelerate their diversification away from the dollar.”
The impasse over the US debt ceiling may, counter-intuitively, have provided the dollar with support, as rising risk aversion boosted haven demand for the US currency, writes James Politi.
Technically the first vote in the US House of Representatives to resolve the issue is next week. But it is expected to fail. Republicans will vote against a proposal to raise the ceiling by $2,400bn without any spending cuts to show there is not enough support for Democrat spending plans.
The real vote to approve a debt ceiling increase will probably be in July, though Democrats would like to see it earlier.