US greenback on the skids

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The comments below were provided by Peter Greene of Fusion IQ.

The financial and economic turmoil behind the dollar’s appreciation earlier this year has eased significantly. Improving fundamentals and increased appetite for risky assets such as equities have reduced the dollar’s appeal as a haven, and it appears to have peaked as the equity market bottomed out. Investors are showing an increasing appetite for commodity and energy assets. The apparent success of China’s stimulus has boosted demand for raw materials, which has increased the appeal of commodity currencies, including the Australian and Canadian dollars, as well as emerging-market currencies, including the Brazilian real. The early recovery in Asia should bolster the commodity currencies and put further downward pressure on the dollar in the near term.

The dollar’s depreciation is causing global monetary authorities to react to volatile shifts in the flow of capital and changes in market sentiment. After sharply reducing total foreign exchange holdings in US dollars as a percentage of total reserves, central banks reversed course and increased those holdings in the first quarter of 2009.

dollar-s

However, that increase will prove transitory. Holdings in dollars as a percentage of total reserves have shrunk from 73% in 2000 to 65% at the end of the first quarter of 2009, a trend that predates the recent financial crisis. In the near term, the trade-weighted dollar index again strongly suggests further diversification away from the greenback as the global economy emerges from recession. Further downward pressure on the greenback is a strong probability through the end of the third quarter.

This has two important implications. Firstly, most global central banks are merely just reacting to global events. Flows of capital are in part formulating the composition of reserve assets and central banks are worsening volatility in foreign exchange markets rather than softening it. The recent depreciation of the dollar, followed by bouts of safe-haven buying (such as last two trading sessions), suggests this volatility will only increase.

Secondly, the inventory-inspired revisions of US output in the second half of the year will be strong enough to diminish the dollar’s haven appeal, which has been its only real support. But the growth numbers will not be strong enough to reverse the cyclical factors behind the depreciation. Rate differentials between the Federal Reserve and other major central banks will keep the dollar weak until policy rates begin to normalize in 2010 at the earliest.

Source: Peter Greene, Fusion IQ, August 11, 2009.

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