Contrasts Weigh on Dollar

The US dollar is mostly lower as shorts get re-established after yesterday’s squeeze. The contrast between The ECB’s continued commitment to an exit strategy, leading to firmer euro zone interest rates, while the FOMC minutes underscore the Fed’s willingness to ease further was brought into stark relief yesterday, cutting short what had appeared to be the beginnings of a corrective phase for the dollar.

At the same time, the combination of strong Chinese reserves figures ($2.65 trillion vs $2.45 trillion at the end of June) and the commitment not to raise interest rates this year means that the world’s three biggest economies will continue to be a source of liquidity and this is encouraging flows into equities, commodities and emerging markets. In the foreign exchange market this is reflected in the relative under-performance of the yen and Swiss franc.

The US dollar’s heavy tone is not simply a function of the prospects that the Fed will soon begin a new round of long-term asset purchases, but it also the contrast with Europe. It is not just that US rates are easing, but that European rates are rising too. Three-month Euribor is up for the 12th consecutive day, for example. The BBK’s Weber, who is tipped as the most likely to replace Trichet at the helm of the ECB in a year, was exceptionally hawkish yesterday, warning that the ECB could lift rates before all its emergency facilities had ended. It is well known that he opposed the ECB’s sovereign debt purchases and yesterday called for their termination. Shortly after Weber’s comments, the FOMC minutes removed any lingering uncertainty that the Fed was poised to resume its Treasury purchases. Perhaps even more important, as this had been largely discounted, was that there were extensive discussions on other measures to boost inflation expectations.

While the diverging paths undermine the dollar, there seems to be a misconception related to the transmission mechanism. There has been much talk that the dollars the Fed is about to “print” to finance their Treasury purchases are being sold and are flowing into emerging market countries and hence the number of emerging market countries intervening in the foreign exchange market or putting on capital controls to slow the inflows.

However, this simplification misses several key points. The Fed will purchase Treasuries by crediting the bank’s accounts. Bank have been keeping the vast majority of these funds at the Federal Reserve—neither lending it out nor buying much in the way of securities—and getting paid 25 bp to do so. No doubt money is flowing to developing countries. The cyclical component is fueled by the expected relative risk adjusted returns in emerging markets vs the developed markets. This may be responding to the same forces that are making continued QE necessary in Japan, and to be resumed in the US, and possibly in the UK. However, there also appears to be a structural element as American, Europeans and Japanese investors appear to be embracing emerging markets as a permanent part of portfolio diversification.