Because Treasuries are Safe Haven, Dollar is Not

The US dollar has been unable to find much traction in recent days despite the heightened tensions in the Middle East and North Africa. The price action has raised questions about the dollar's role as a safe haven.

What does seem to be a safe haven are US Treasuries. Despite greater confidence that the US economy has gained momentum, the US yields have fallen. Some of the rally in Treasuries may be reflecting portfolio shifts away from equities and toward fixed income. Anecdotal evidence suggests a good foreign bid as well. Demand from indirect bidders, which include foreign central banks, was above last month's for the 2 year note, but was a little softer for yesterday's 5-year note, but still took down a little more than a third.

Today the US auctions $29 bln 7-year notes and despite the lackluster overall demand for the five year, the safe haven demand has prevented a concession to be built. In some ways, in the current environment it is precisely because the US Treasury draws a safe haven bid, because its depth and transparency, that weighs on the dollar through the interest rate channel. The US dollar continues to track the movement of interest rate differentials. My work has emphasized 2-year interest rate differentials.

In addition to the interest rate channel, another force blunting the safe haven impact on the dollar, is the reserve management associated with higher oil prices. Consider for example, an oil producer whose central bank maintain a 60/40 split of reserves between dollars and oil. The transactional demand for dollars related to the higher price of oil is minor compared with the diversification of the new petrodollars.

Of course, this is all taking place in the larger context of divergent monetary impulses. The 6-3 vote at the UK MPC earlier this month and speculation that it could be a 5-4 vote next month if Bean joins the hawks has fanned expectations of a hike in the middle of Q2. While we recognize the pressure, we also recognize that the impact of the backing up of UK rates and the austerity is going to have some adverse economic impact and this was evident in the poor CBI retail trade report, which fell to its lowest level since last June and the outlook for March was cut sharply. Lastly, the leading hawk of the MPC's term expires in a couple of months and the most likely replacement (according to the UK press) is much less inclined to raise rates.

ECB official rhetoric has clearly increased a few decibels. Yet a rate hike is still not the most likely scenario. Recall that before Irish problems reached a climax of sorts last November, the ECB had seemed to signal the ending of its 3-month unlimited lending facility. The Irish crisis prevented it from implementing it, but signalling this for Q2 seems like the next more likely step.

Germany confirmed that its economy grew 0.4% in Q4 10. With the confirmation comes more details and there were several surprises. Domestic demand actually contracted (-0.4%). Foreign demand prevented the German economy from contracting as exports rose 2.5% on the quarter while imports rose a more modest 0.9%. Digging a little deeper consumption increased by mere 0.2%, despite the numerous press reports that played up a resurgent German consumer. The 1.1% drop in capital investment offset the meager consumption.

The German economics minister quickly opined that the drop in investment was only temporary. That may very well be but my overall point remains valid: German growth remains highly dependent on foreign demand and many of its trade partners, including in Asia, look to slow this year and German growth is expected to slow from 3.6% last year to 2.5% this year, according to the Bundesbank.