The dollar is on course to post its largest quarterly advance in 15 years.
Bank of America, though, continues to advance a contrarian theory: the rise and rise of the dollar has been a factor of market illiquidity.
One of the earliest sources of support for the US currency seems to have come from rising tensions in the money markets, as exemplified by the record high levels posted by the three-month USD LIBOR-OIS spread. The severe lack of USD liquidity created incentives for foreign banks to buy dollars in the currency markets with funds received from liquidity enhancing schemes of their own central banks, creating a way to meet USD funding needs without paying the soaring interest rates associated with the Eurodollar markets.
Which of course begs the question: now interbank funding mechanisms are normalising (or at least, reserve levels soaring) are we likely to see a collapse in the dollar?
Or perhaps that should be: given the liquidity support provided to the market over the past month - for example the massive swap lines the Fed has extended to central banks around the world - why haven’t we seen a collapse in the dollar?
Partly because of the equity sell off:
As the tensions in money markets started to ease, a USD retracement was largely prevented by a repatriation bid created by the sharp declines posted by global equity markets.
Bank of America’s FX desk has in fact held the view that the dollar is being artificially propped by market liquidations for a couple of weeks now. A key factor to watch being the VIX. As volatility falls off, so will the dollar.
There is a more extreme version of this BoA view. One advanced yesterday by Jim Rogers in the FT:
…we’re in a period of forced liquidation of everything. We’ve had only eight or nine periods like this in the past 150 years, where everybody has to reverse their positions on everything. There is a gigantic short position in the dollar and they’re all having to cover as they reverse their positions, so this rout is going to go on much further than I would have expected - to my delight, because then I’ll get to sell at higher prices. I don’t know whether I’ll get out this month or this year even - maybe next year, but I do plan to get out of the rest of my US dollars, because this is an artificial rally caused purely by short covering.
…the dollar is a flawed and, maybe, even doomed currency.
Brad Setser at the CFR has a good graph to illustrate just that kind of thing. “Foreign demand for any US bond with a smidgen of credit risk has disappeared”:
As Setser notes:
Normally, this kind of fall-off in foreign demand would be associated not just with a credit crisis but also with a currency crisis. A country cannot finance a trade and current account deficit without financing, and two big sources of financing for the US deficit - foreign purchases of Agencies and US corporate bonds - has disappeared. The US, though, isn’t a normal country. The fall in demand for risky US assets was offset by a rise in demand for Treasuries and the sale of foreign assets by Americans.
Whether you subscribe to the more strategic, long-term bearish view or not, there are nonetheless plenty of shorter-term indicators that point to a overpriced greenback.
This chart for example. Of the 10 year bund-treasury spread plotted against the EUR/USD:
Related links
If all else fails, devalue the dollar - FT Alphaville
Fed swap lines: massive mark-to-market “losses” - Alea
Jim Rogers on the dollar - FT video
