Dollar's Safe Haven or Beneficiary of Short-Covering

The narrative told by many is that as the financial crisis became more acute, capital from around the world flocked to the US Treasury market, and especially the short-end of the curve, for security. The dollar was driven higher on safe haven flows and now as the financial crisis has eased and some turning of second derivatives--pace of contraction slowing--the safe haven demand has eased and the dollar has fallen.

There is another narrative. It does not begin with the crisis as the other narrative, but begins with the run-up to the crisis. Rather than security and safe haven demand playing the pivotal role, in this narrative leverage is center stage. It explains why the dollar was weak well into the crisis. European banks, hedge funds, global investors from Brazil and Mexico, to Russia and South Korea borrowed dollars and often brought the money home and lent or invested locally. As the crisis intensified, there was in effect a global margin call and those dollars had to be bought back. The currency swap lines the Fed arranged and expanded provided the dollars to numerous countries to meet the margin call.

The importance of the narrative is in what is says about the future. The first narrative would be more dollar negative. As the world economy recovers, the dollar will suffer as the safe haven flows reverse. The second narrative is not a dollar negative. Global investors may not be as over-weight dollars as the first narrative would suggest and therefore the wherewithal to buy more as growth (not contraction) and rate differentials move into the US favor.

Ultimately it is a question of emphasis. Clearly there was some safe haven demand. Clearly there was some de-leveraging. The TIC data did show unusually large buying of US securities in Q4 last year (monthly average $134.3 bln). Digging a little deep, the surge of inflows took place in the Sept-Oct period--seemingly related to the intensification of the crisis following the collapse of Lehman.

In the Q1 2009, there was an average monthly outflow of about $70.5 bln. A total of $234.6 bln outflows were recorded in Jan and Feb and turned small positive in March. Note however during the Jan-Feb period when hefty outflows were being recorded the dollar rallied. In fact the dollar on a trade weighted basis reached a three-year high in March and has since of course moved lower. The unwind of the dollar's safe haven hypothesis as the main driver does not seem to be consistent with the TIC data.

The Commitment of Traders data is not very supportive either of the safe haven thesis. Look at the euro. Speculators were net long euros form December 2006 through May 2008. Last spring positions swung around a little, but between August 08 and March 2009, speculators were short euros. For the record, the euro made its lows in late Oct.

Another advantage of the second narrative that emphasizes leverage is that is also can explain the weakness and then strength of the yen, and to some extent the Swiss franc.