Business

Monday November 9, 2009

US dollar as funding currency to boost volatility, high yielding assets


IN an effort to spur an economic recovery from the worst slump since the Great Depression, the Federal Reserve (Fed) has slashed the Fed Funds target rate from 5.25% in September 2007 to 0.25% currently.

If that is not enough to boost liquidity, the Fed has also printed money and expanded its balance sheet from US$900bil in September 2008 to US$2.2 trillion currently.

With so much money sloshing around and with little need of the money for real economic activities, it is no wonder that US interest rates have stayed ultra low.

The US dollar is not a natural funding currency as it suffers from both a trade and budget deficit, therefore, needs to borrow.

The yen would be a more natural funding currency. Japan had excess savings and trade surpluses resulting in excess liquidity as there is little demand for money in an anaemic economy.

However, this time round, the sheer scale of the downturn has forced the US authorities to generate an avalanche of liquidity at a time when economic activity and bank lending is weak.

Banks keen on earning a decent return on their surplus US dollars have kindly acquiesced to lending their US dollars to speculators to purchase financial assets.

Alas, nothing much has changed. It was the Fed that allowed excessively low interest rates to fuel an unprecedented US housing bubble that led to the global financial crisis and now the same Fed has pumped excess liquidity into the system that has encouraged another bubble in financial assets financed by cheap US dollars. Perhaps a bigger bubble is needed to compensate for the one that burst.

The US dollar three-month libor rates (often used as a benchmark for short-term borrowing costs) have fallen from 2.8% before the crisis to around 0.28% currently as shown by the chart above.

The spike in the three-month libor rates to 4.8% in October 2008 was due to banks distrusting each other’s credit standing after the collapse of Lehman Brothers.

The three-month libor rate has fallen below the three-month libor of the yen which was previously the preferred funding currency.

This means that speculators and hedge funds can enter into a carry trade by borrowing the US dollar to buy high-yielding currencies like the Australian dollar with a three-month libor rate of 3.92%.

There are many ways of using a currency which is seemingly depreciating and offers low interest rates.

Some would borrow to buy long-dated US treasuries like the 10-year bond with a yield of 3.39%.

Others might even borrow US dollar to buy stocks with high yields or even speculate in commodities as conventional wisdom expects commodities (with real value) to appreciate as the US dollar (a depreciating paper money) loses value.

The table shows some of the positive carry which could be enhanced through gearing. So what is the catch? This happens when the US dollar appreciates rather than depreciates or when interest rates rise. Ironically, the US dollar is seen as a safe haven due to its reserve currency status.

Rightly or wrongly, the perception is that the US dollar can be exchangeable into something which may not be the case if one holds the currency of a banana republic like Zimbabwe.

Therefore, if there is a financial shock resulting in a lower risk appetite, the appreciation of the US dollar may force the unwinding of the US dollar carry trades just like the unwinding of the Japanese carry trades following the failure of Lehman.

This effect would increase the volatility of the US dollar exchange rate and sustain the volatility in asset classes that have been purchased using borrowed US dollar.

Unfortunately, this would include a broad range of products like gold, commodities, high-yielding currencies, treasuries and equities. Looks like volatility is here to stay.

The other danger is when the US economy recovers in a sustainable way resulting in the Fed raising interest rates which would make the carry trade less attractive due to higher US borrowing costs.

The Fed has indicated that it is likely to keep interest low until a recovery is evident which is likely to be mid-2010 at the earliest.

Though the Fed may not say it, letting the US dollar depreciate has its advantages for the US. First, it boosts US competitiveness (in the short term) and exports. Second, it reduces the debt owed to foreign countries (China and Japan) in real terms.

Third, it has a reflationary effect as it boosts commodity prices and even stocks as more than 50% of profits from top US companies are derived from overseas. Fourth, it makes US assets cheaper and attracts foreign investments in US property, stocks and businesses. Of course, there are dangers like an erosion of confidence in the currency and hyper inflation (unlikely in the short term due to excess capacity).

A depreciating US dollar enhances its appeal as a funding currency.

However, the depreciation is likely to be against major currencies like the yen, euro and Australian dollar rather than against US dollar bloc currencies like the Asian currencies.

With its large trade surpluses and strong economy, the remimbi will come under pressure to appreciate.

Judging from the need for US consumers to reduce their debt from record levels, the US economic recovery is expected to be weak even as it grew quarter-on-quarter by 3.5% in the third quarter helped by subsidies for the purchase of cars and houses.

A weak US economy would mean low interest rates, allowing the US to be the funding currency for some time. Brace yourself for a volatile reflationary ride punctured by sharp dips during moments of psychological doubts.

l Choong Khuat Hock is head of research at Kumpulan Sentiasa Cemerlang Sdn Bhd

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