US dollar under pressure

In currency markets the risk aversion theme appears to be changing. The situation started with the market punishing high yielding currencies, altogether benefiting the Japanese yen, Swiss franc and the US dollar. However, it was always thought that the US dollar's resilience would prove temporary. Indeed, early signs of the US dollar weakening are appearing more evenly, as US fundamental data disappoint and the US Federal Reserve lowered the Fed Funds rate by 50 basis points. The US dollar is at risk of falling further.

Although the US dollar has weakened in the wake of a disappointing payrolls report, it is still trying to hold up against some currencies. Looking at the US dollar's relative performance compared to other currencies since the peak of the equity markets in July until the end of August, it outperformed all major currencies except the yen and Swiss franc.

There are a number of factors that helped support the US dollar, even though US growth prospects have dimmed and Fed rate cut expectations have risen before they became a reality a couple of weeks ago. In an environment that had been so highly focused on relative yields, a lower US interest rate profile should be negative for the American currency, but clearly its relative buoyancy is a function of other drivers.

Calmer market

The first factor believed to be lending the US dollar underlying support is the fact that the volatility in the corporate bond market has actually subsided and corporate bond spreads have narrowed from their previous wide levels. Since the corporate bond market recovered slightly and the financial market problems moved on to the equity sphere, broad negative pressure subsided and the focus has since migrated towards currencies that are tied more to the equity market.

Given that US investors tend to be very equity-oriented, the rationale was that they would de-leverage from global equities, lending the US dollar some support. Indeed there is some evidence to suggest US investors reduce their exposure to foreign equities when the market is under downward pressure.

International equities

The idea being pursued is that US investors redeem a significant amount of funds from overseas during periods of market stress. For instance, looking at data from the Investment Company Institute (ICI), which covers nearly 90 per cent of US mutual funds, one can gauge, in part, what US investors have been up to.

Using the ICI data it can be seen that redemptions from international equity funds tend to increase when global equities are suffering. The redemption flow from international bond funds were also looked at; however, the moves have been insignificant in comparison to the equity flows.

One of the key views over the past year is that European currencies were benefiting from US investors buying relatively greater amounts of European equities compared to elsewhere. The pace of buying European equities has been accelerating since the global equity market decline in May 2006.

However, this buying of European equities also highlighted the vulnerability of European currencies if a significant equity market downturn emerged, something that has been consistently highlighted. In other words, US investors would be quick to reduce their exposure to European equities and the redemption flow would see the US dollar hold up well versus European currencies.

The fact that the US dollar outperformed European currencies during the latest equity tremor should not come as a surprise. If further equity market declines occur, the US dollar is expected to temporarily strengthen versus these currencies.

USD liquidity factor

It may be that some foreign investors are purchasing US Treasury bills, on an un-hedged basis, as a safe haven trade. In addition, the scramble by financial institutions for short-term liquidity could also be indirectly supporting the US dollar. Also, from a currency perspective, clearly the US dollar is an ideal source of liquidity and played an integral role in the yen carry trade.

The three factors that have been identified as supporting the US dollar are more capital flow-oriented. The renewed US dollar weakness is predicated on two key factors. First, the risk aversion theme would remain in the US but conditions elsewhere would be less acute. Second, the US dollar's fundamental backdrop would need to show greater evidence of independent weakening compared to elsewhere, and importantly more than the market may have already discounted. It appears these conditions are becoming realities especially after the weakness recently seen in the US labour market and the cut in the Fed Funds rate.

From a fundamental perspective, a substantive lurch down in the US dollar would be consistent with fresh evidence of an economic decoupling, where the US economy slows but the rest of the world holds up relatively well. This may take some time for investors to accept, given there is a sense of financial market contagion in some of the developed economies. If US data weakens consistently more than the market is thinking, this would be an important turn of events. The risk aversion theme would become overshadowed by a weaker US growth profile, seeing the situation become more of a US dollar-centric issue. Once this reality sinks in, the US dollar will weaken across the board.

This report was compiled by Peter Calleya, manager Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.