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Forex Blog - Dollar Breaks with Risk Aversion Theme?

Dollar Breaks with Risk Aversion Theme?


Speculation abounds in the last week that correlations in markets between currencies and asset prices are weakening.  In particular the argument is made that the USD is ignoring risk aversion as the central motivating theme for FX…risk aversion up, stocks down, risk assets down, risk currencies down and dollar and yen up.  In its place is the reflation theme.  Obama is going to spend his way to US prosperity no matter the cost and the Fed is going to buy its way to prosperity no matter the cost.  Profligate government spending and monetization of debt are recipes for a run on the dollar. 


I am a believer in this trade, weakening correlations and theme change.  However, I am not convinced of the timing as in now.  Pricing in the end result before deflation has reared its head and the Fed succeeding in creating inflation, all of which assumes restoring confidence in risk taking reminds me of the woman runner who jumped on a subway and road it to the finish line of the Boston marathon to claim victory with barely breaking a sweat. 


Japan’s reflation took years to produce inflation and years to generate a weaker yen (having an external surplus as opposed to a massive US external deficit makes a major difference) should offer some warning to those ready to put banking anxiety and economic recession/depression to bed and bet on hyperinflation outcomes for the US currency.  JGB yields also stayed low through the entire reflation period disappointing many betting on a major decline in price. 


Okay Japan moved slowly to monetizing and failed to make its banks write off bad loans until late in the game and the US has moved rapidly and significantly in all aspects of the crisis.  But I don’t think we can dismiss all the lessons from Japan’s lost decade and attempts at reflation.


I also think official rates in developed countries are converging to zero or close to zero…yes even in the Euro Zone albeit reluctantly.  Maybe the Fed takes to quantitative easing first and the dollar has ground to surrender in the process (we should know more about this next week).  But how long before the BOE is engaged in QE?  Indeed the SNB may get there ahead of the Fed as the SNB cuts rates this week from 1.00% and this central bank is not anywhere near where the ECB is in terms of denial over the magnitude of financial and economic crisis.  Can there be a run on the dollar for reflating when most central banks and governments are also pursuing a policy mix of reflation?


One story line which may explain the recent USD weakness in the face of elevated risk aversion and falling stock prices that deserves more consideration is that the Fed’s swap lines with major central banks across the plant have made dollars readily available to the banks thereby eliminating one major source of dollar buying in the spot market – banks desperate for dollars to fill gaping holes in dollar balances from crashing asset values and deleveraging.   Banks had been borrowing funds from central banks and in turn selling local currencies for USD to patch up balance sheets.  According to this line of reasoning, banks across the planet can now easily obtain USD from local central banks via large swap lines the Fed has with major central banks. 


I might add to the above reason that major bank write downs have gone silent – maybe this is due to the reporting calendar (there is always Q4).  But I suspect banks will have new holes to fill on balance sheets ahead as they take hits on ABS and other lines of credit on top of fresh residential mortgage-related losses and we shale see if swap lines are adequate to fill billions more in write downs through 2009 as the real economy folds.  And stocks face significant downside risk well through 2009 as corporate earnings get flattened. 


So it is too early in the crisis and policy response for me to throw the risk-aversion theme away with the bath water.  Like the counter trend rally in stocks, recent dollar declines are real and demand respect.  But these are not indications of changes in trend and dominant narratives. 


I do think the dollar is the shock absorber to reflation policies in the longer-term, just not now and not for much of the first half of 2009.


David Gilmore



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