Central Bank Diversification Putting Pressure on USD
While oil prices, concerns about US growth, ultra-loose monetary policy and interest rate expectations, and budget battles in Washington are garnering most of the headlines in regards to the USD, an undercurrent that is fueling recent USD weakness is the growth of diversification flows.
Asian central banks are trying their best to intervene to stop their currencies from rising too far. They do that by selling their currency and usually sell them for US Dollars. They are then stuck holding US Dollars which they may not want and are sending those funds abroad and bringing back other currencies – like the EUR or other higher yielding currencies.
A similar dynamic was happening as oil prices surged and Middle Eastern central banks were flush with extra US Dollars as well.
From Forbes Blog: Nomura’s FX research and strategy team analyzed the latest numbers from the Treasury’s International Capital System. “It looks like the trend of weak central bank demand for USD assets is persisting into 2011 (after a very weak Q4),” wrote Nomura’s global head of G10 FX strategy, Jens Nordvig in an email. From November to January, central banks reduced their US dollar holdings by $9 billion; “given a fairly strong trend in global reserve accumulation over the period, this points to a declining USD reserve share,” noted Nordvig.
While this chart is a bit dated, this dynamic continues toady. Why the move out of the Dollar for these central banks? Well, there are the factors listed above, and let’s delve a little bit deeper into each.
Budget Concerns Raise Risk of US Default
One of the most direct worries for the USD is the prospect that Washington will again be embroiled in a fight over spending, the deficit and the debt as the US Treasury approaches the current debt ceiling of $14.3 trillion. A failure to extend this debt ceiling would mean that the US technically would undergo a debt default, a possibility that would cause widespread uncertainty in financial markets.
The down to the wire negotiations over the current budget almost shut down government and the Republicans are ready and eager to use the debt ceiling battle as a way to get more concessions from the President and the Democrats.
With the heated debate in Washington, at this point the risk of a US default is growing, and that will cause US Treasury prices to fall and yields to climb as investors demand a higher yield to account for that risk.
Usually higher yields might help a currency as it attracts foreign investors, but in this case its not growth and inflation prospects causing yields to climb but worry over default. That won’t do the USD any favors.
Interest Rate Expectations and the Battle Within the FOMC
Next up in terms of factors pressuring the USD is the theme we have seen throughout the last two years and that is the ultra-loose monetary policy being carried out by the Fed. The last few weeks have seen important developments on this front in that first off, higher inflation has caused the ECB to raise rates, widening the interest rate differential between the ECB refinancing rate and the Federal Funds rate to 100 basis points. More rate hikes are expected from the ECB, which will only widen rate differentials.
At the Fed meanwhile, the talk from the Fed’s hawks has been met by a swift rebuke by the 3 members of the FOMC whose opinions carry the most weight – that is the Fed Chairman Bernanke, the Vice Chairman Yellen, and the NY Fed President Dudley. They, along with the other doves on the FOMC, have let it be known that the current pick up in inflation in “transitory” and that higher commodity and energy prices will ease of their own accord and that in the medium term, underlying inflation remains subdued.
That message has made it quite clear that the Fed is not ready to begin tightening policy, and the battle between the hawks and doves will come in June when the Fed will conclude its full allotment of $600 billion of Treasury purchases as part of its QE2 program. If the economic data disappoints, its also feasible that the Fed can even expand QE2. That may be a non-starter with the other FOMC members, but all in all the doves have carried the day and as a result interest rate expectations continue to disadvantage the USD.
Growth Concerns as 1Q GDP Projections Revised Lower Post Trade Data
Adding to the mix of default risk and interest rate expectations was softer data this week from the trade side. Trade had helped GDP growth in the 4th quarter – along with a surge in consumer spending. Data for February’s trade balance however showed exports taking a step back, declining 1.4%. imports were down 1.7%, and overall the trade deficit narrowed by a smaller than expected amount for the month.
The news caused economists to revise lower their 1st quarter GDP figures:
From Marketwatch: “After the data came out, many economists — including Morgan Stanley, RBS Securities and Macroeconomic Advisers — slashed forecasts for first-quarter growth in U.S. gross domestic product to well below a 2% rate.
The economy expanded at a 3.1% rate in the last three months of 2010, helped in large part by higher exports, but this positive contribution has reversed in the first three months of the year. Ian Shepherdson, chief U.S. economist at High Frequency Economics, forecast that trade will drag first-quarter GDP down by 1%.”
Recipe for USD Weakness in 2nd Quarter
While retail sales data today helped show that consumer spending remains quite resilient to end the 1st quarter, the March figures came in pretty close to expectations so it wouldn’t shift the perception about overall growth.
Recent risk aversion in equity markets stalled some of the advance of higher yielders against the USD, but equities brushed off the weak sentiment from the first half of the week, and Asian and European equities rallied.
In fact its the search for higher yields that will continue to be the USD worst enemy, as the Fed’s ultra-loose monetary policy will continue to cause the USD to be used as a funding currency for “carry trade” – the process of borrowing in a low-interest rate currency to park the money in a higher yielding currency and pocketing the difference between the two (as long as exchange rate don’t go against your trade and wipe out these carry gains).
The search for higher yield means that Asian and Middle Eastern central banks will continue to recycle any US Dollars they receive – from intervention or from selling oil at higher prices – into other currencies, weakening the USD.
Therefore, even if the USD can correct some of the steeper losses it has suffered since mid-March against its key rivals, we shouldn’t expect a strong turnaround for the USD in the 2nd quarter. Especially as the time comes closer for other central banks to being tightening rates – Bank of England, Bank of Canada – the USD will come under selling pressure.
Only Sharper Inflation, Strong Job Growth Can Change This State of Affairs for USD
Data coming up this week can jolt some of these expectations, but it doesn’t seem likely. We have both producer and consumer inflation data for March on tap. A surge in headline inflation is already expected, but its the core readings that the Fed will be paying attention to, and the forecasts are for mild 0.2% increases in both the “core” PPI and CPI on a monthly basis. Even if prices surprise for March, the doves on the Fed will not be convinced until more evidence points to higher underlying inflation.
Manufacturing and jobs data will help gauge the economy. We are looking to see a bounce back in the manufacturing sector, while jobless claims are expected to remain near the 380K level.
A strong pick up in job growth – even better than the 217K we saw in February - along with higher underlying inflation would be the two key fundamental factors that can help turn the state of affairs around for the beleaguered USD, as that would be what is needed to turn the doves away from the current ultra-accommodative monetary policy.
Nick Nasad
Chief Market Analyst
FXTimes
Information and opinions contained in this report are for educational purposes only and do not constitute an investment advice. While the information contained herein was obtained from sources believed to be reliable, author does not guarantee its accuracy or completeness. FXTimes will not accept liability for any loss of profit or damage which may arise directly, indirectly or consequently from use of or reliance on the trading set-ups or any accompanying chart analysis.
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