Dollar to collapse?

Many people predict the imminent demise of the US dollar because of the massive money creation by the Fed. Not so fast, gentlemen, the dollar is alive and kicking…

You might not be aware of it, but with the likes of Germany and Japan shrinking 6% or more, the US economy is actually doing pretty well, on a relative basis. It’s also expected to be the first mayor economy (apart from China, but it’s currency is not freely tradable on the foreign exchange markets) to come out of the recession.

This makes dollar denominated investments relatively attractive. The best policy reaction (again apart from China, whose banks, although exposed to domestic problems like falling property prices, and fiscal position are in better shape) also came from the US authorities (although we’re no fan’s of the Geithner bank plans).

European banks are much more exposed to dud loans to it’s fringe countries, and it’s policy response has been less coherent.

Even in case of the crisis worsening, the US dollar will remain strong, on it’s safe haven status. So, we don’t see that imminent dollar collapse. And neither does Bloomberg. Either the economy is doing well, and foreign money move into US stocks, or it isn’t, and foreign money move into US bonds. Whichever way, it’s good for the dollar (see article below).

One cloud at the horizon is that China seems diverting into gold, which might be an ominous sign. On the other hand, the US trade deficit is declining briskly, as the private sector saves more and spend and invest less, which is supportive of the dollar (with a lower trade-gap, the US needs to sell less assets abroad to finance it).

Dollar Wins Heads-or-Tails Toss on Growth or Weakening Economy

By Oliver Biggadike

April 27 (Bloomberg) — Former Federal Reserve Chairman Alan Greenspan said five years ago that predicting currencies is no better than tossing a coin. A growing number of traders are betting that heads or tails, the dollar wins.

Investors bullish on the U.S. economy say the dollar will strengthen as America recovers first from the global economic recession. Those who expect the longest contraction since the early 1980s to continue say the currency should appreciate as the haven from turmoil in world markets. Foreign investors bought a net $22 billion of U.S. financial assets in February, the Treasury Department said April 15.

The dollar is “the best-looking horse in the glue factory” among major currencies, said Robert Blake, head of strategy for North America in Boston at State Street Global Markets LLC, which has $11.3 trillion in assets under custody.

America’s currency is rising even as the Treasury sells record amounts of bonds to finance a deficit the Congressional Budget Office estimated will swell to $1.85 trillion this fiscal year. Intercontinental Exchange Inc.’s Dollar Index, which measures the greenback against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona, is up 4.2 percent this year, after falling 5.4 percent at this point in 2008.

Strategists increased their forecasts for the dollar this year against all those currencies, data compiled by Bloomberg show. Since January, the analysts have boosted their year-end dollar forecast 2.2 percent to $1.32 per euro from $1.35, and 5.2 percent to 101 yen from 96 in February, the median of more than 40 estimates compiled by Bloomberg show.

Boosting Forecasts

The U.S. currency strengthened to $1.3242 versus the euro last week from the low this year of $1.4058 on Jan. 2, and Blake predicts it will rise to $1.28 in a month. Against the yen, the dollar appreciated to 97.17 from the low of 87.13 on Jan. 21, and will likely rise to 102, he said.

Much of the dollar’s gains came as the deteriorating global economy caused investors to flee stocks and emerging market bonds and reinvest their money in Treasuries. Rates on three- month Treasury bills have averaged 0.19 percent this year, compared with 1.27 percent in 2008.

The 30-day correlation coefficient between the Dollar Index and Morgan Stanley’s MSCI World Index reached negative 0.72 on Feb. 19, the most since July 2006, as the greenback approached a three-year high against its trading partners and global stocks fell. A correlation of minus 1 would mean the dollar gains whenever stocks decline.

Seeking Signs

Now, the dollar is gaining as stocks rally, signaling investors see the economy bottoming and are putting their money in U.S. assets.

The Dollar Index rose as much as 5.1 percent since March 19 as the MSCI World Index rallied 11 percent. The 30-day correlation coefficient narrowed to minus 0.55 in that period.

“If there’re signs that the U.S. is the first out of the recession, it’s beneficial for the dollar,” said Samarjit Shankar, director of global strategy for the Global Markets group in Boston at Bank of New York Mellon, which administers more than $20 trillion in assets.

Purchases of new homes in the U.S. were higher than forecast in March and German business confidence rebounded from a 26-year low this month, data on April 24 showed. The same day, finance chiefs from the Group of Seven industrialized nations said in a joint statement they see “signs of stabilization.”

Recovery Forecast

“Economic activity should begin to recover later this year amid a continued weak outlook, and downside risks persist,” the G-7 finance ministers and central bankers said in the statement.

Greenspan, who stepped down as Fed chairman in 2006, compared the accuracy of currency predictions to tossing a coin in November 2004 at the European Banking Congress in Frankfurt.

“Forecasting exchange rates has a success rate no better than that of forecasting the outcome of a coin toss,” he said in a speech in which he warned that the U.S. current account deficit would diminish the appeal of accumulating dollar assets.

Strength in the dollar may be tempered as the Fed prints money to purchase U.S. debt in an attempt to keep yields from rising, according to Jonathan Xiong, who helps manage $18 billion in foreign exchange as a senior portfolio manager at Mellon Capital Management Corp. in San Francisco. The U.S. central bank’s balance sheet rose to $2.2 trillion as of April 22 from $906 billion at the beginning of September.

“You’re issuing your own debt and buying it back in the marketplace; that definitely will have to devalue the currency,” he said. “The big powerhouses like China do have a little bit of concern.”

Rising Demand

So far, data show undiminished foreign demand for U.S. financial assets. Net purchases totaled $22 billion in February as China and Japan added to their holdings of U.S. government debt, the Treasury said. The Fed’s holdings of Treasuries on behalf of foreign central banks and other institutions rose 8.7 percent this year to $1.84 trillion.

More foreign money flowed into U.S. stock markets in the 20 business days ended April 15 than in 69 percent of the other 20- day periods going back to 1997, according to State Street data. The five-day flow was in the 77.6 percentile, compared with outflows in the last six months that were higher than 86.4 percent of past periods, the data showed.

We’re at a loss to identify other major currencies that look more attractive” than the dollar, State Street’s Blake said. “The equity-flow data have been dollar supportive almost any way you look at it. When people flood into the equity market they’ve been buying the dollar as well.”

Shrinking Deficit

Jim O’Neill, chief economist at Goldman Sachs Group Inc. in London, said a shrinking U.S. trade deficit will spur demand for the U.S. currency. He said in an April 21 interview that February’s 28 percent drop to $26 billion “means this massive commercial overhang of excessive supply of dollars coming from the trade deficit is basically being taken away.”

“What that tells you is that the funding problem has effectively been cut by a third already,” he said. “So I find myself these days difficult to be that bearish on the dollar, which is the base for me for the past 25 years. It’s really quite a big change.”

O’Neill predicts the dollar may rise as high as 110 yen in the next six months. He also reiterated his firm’s prediction that the U.S. will expand about 1 percent in the third quarter.

The Dollar Index largely followed the U.S. trade balance in the past nine years, rising to 117 in December 2001, the last time the gap was close to $26 billion, according to analysts at Citigroup Inc. in New York that use trading patterns to predict future price movements.

“Wow … wow … wow,” technical analysts Tom Fitzpatrick and Shyam Devani wrote in a report on April 9. “This dynamic could be extremely dollar positive.”