Well what do you know? All sorts of people, governments and institutions have been blamed for dollar weakness. But contrary to popular presumption, says Stephen Jen, Morgan Stanley’s global head of currency research, US real money managers are the biggest dollar diversifiers, not the Asian central banks.
Controlling about $20,700bn in assets - four times the size of the total global official foreign reserves - US real money managers have been diversifying aggressively out of the US since 2003, says Jen. And if you buy his line that ‘currency diversification equals currency weakness’, this explains why the dollar has shown a gradual downtrend since then - and why it is so weak now.
In a note issued Friday, Jen calculates that cumulative outflows from the US may have totalled $1,160bn in the past four years.
Cyclical explanations for dollar weakness are inadequate, Jen says. “While there are clear cyclical reasons why the dollar has weakened recently, these rather innocuous developments cannot explain why the dollar is so extraordinarily low. Other forces may be at work.”
Enter the real money managers of America. “Diversification is a global trend”, he notes. But the trend doesn’t necessarily indicate that investors have fallen out of love with their own countries’ assets, he says, but could merely highlight prudential development whereby countries are seeking more diversified portfolios.
The “home bias” in real money management, therefore, may well decline, Jen notes. Already, he says, we’ve witnessed this trend in Japan, with retail investors aggressively diversifying out of yen assets. From this perspective, this diversification is part of the global trend, not an idiosyncratic development in Japan.
And as different countries start to diversify their private financial portfolios, exchange rates are affected, says Jen. Obviously, financial globalisation is not necessarily dollar-negative, he adds. “It appears to be dollar-negative now only because the US real money managers are larger and are early in this process.”
The fact that the yen is even weaker than the dollar proves that whoever is more aggressive in this diversification process will see their currency weaken, Jen says.
Ironically, in Europe, despite the presumed need for investors there to diversify out of the euro currency-zone, due to the legacy currencies being replaced by the euro, there have been scant signs of wholesale diversification, “which may be another reason why the euro is strong against both the dollar and the yen.”
The upshot is, exchange rates will be increasingly influenced by these cross-currents, “possibly more so than by economic fundamentals”. This means that exchange rates may be misaligned due to these structural capital flows.
Specifically, says Jen, during the risk-reduction phase in key markets in February-March, “all the G10 exchange rates moved towards their fair values”. But when capital flows resumed and risk-taking recovered, these exchange rates “again drifted away from their fair values”.
To Jen, this suggests that exchange rate misalignments are most likely due to international capital flows that are motivated by factors other than economic fundamentals, such as prudential diversification - or plain old desire to rebalance toward a more diversified portfolio to better capitalise on a globalised global economy.
