Debts & Loans

By cutting rates to just above zero and promising to hold them there until the economy recovers, the Federal Reserve has created near-perfect conditions for a one-way bet against the U.S. dollar.

After four months in which the U.S. currency recorded its biggest gains since 2002, the dollar fell 4 percent yesterday against the euro, one of the largest one-day declines on record.

In the past two weeks, the dollar has lost 12 percent of its euro value, reversing just over half the gains racked up since July. Against a trade-weighted basket of major currencies, the dollar is down 8 percent, wiping out almost half the previous 20 percent gain in four months. And against gold, the dollar is down 14 percent, partially reversing an earlier 25 percent gain.

The sudden turnaround has nothing to do with the economic outlook or trade and financial flows.

The outlook for the U.S. economy is broadly unchanged. Business activity looks set to continue falling during the remainder of the year and well into H1 2009, with any recovery unlikely before H2. But the outlook has not changed in the last ten days, and the euro zone, Japan and China seem unlikely to fare much better.

Meanwhile, underlying trade and investment flows have actually shifted in ways that should be dollar-supportive. After six years in which the burgeoning net offer of U.S. assets to the rest of the world weighed down on the currency, net asset sales have declined substantially over the last year and should remain limited over the next 6-12 months.

Slowing growth and falling oil prices are cutting the current account deficit, while overseas asset liquidation and balance-sheet consolidation have reduced financing requirements on the capital side. Both trends should continue well into next year: (https://customers.reuters.com/d/graphics/US_EXTFIN1208.gif).
The dollar's savaging has instead come at the hands of speculative flows, as the market adjusts to the consequences of unexpectedly aggressive easing by the Fed that have set the scene for more selling over the next few months.

A NEW FUNDING CURRENCY

The Fed's decision has sent a clear signal that borrowing to short the dollar will remain cost-free for an extended period. As a result, the dollar risks replacing the yen as the new funding currency of choice for carry traders.

To speculate against a currency, you need to be able to borrow it cheaply and in large amounts. The Fed has now guaranteed both. In the early stages of the crisis, lack of dollar liquidity in overseas centres such as London and Frankfurt sent interbank rates for dollar borrowing surging and propelled the currency higher.

But the Fed has addressed the dollar drought by extending massive swap lines with overseas central banks, while liquidity in the domestic markets remains at all-time highs, with bank vaults groaning with excess reserves and money market rates little more than zero even before yesterday's reduction in the official target.

By shaving the target cost of overnight costs to just above zero, and reassuring investors it will hold rates at that level for the foreseeable future, the Fed has essentially given traders a cost-free way to borrow overnight, roll positions forward consistently with minimal rate risk, and invest the proceeds in higher yielding assets.

The Fed clearly hopes the increased borrowing will be used to purchase higher-risk financial assets and restart the securities markets inside the United States, as well as financing higher levels of consumer spending and business investment.

But overnight money is fungible. It could just as easily be used to fund purchases of higher-yielding currencies and assets overseas.
For the past decade, the yen has been the favoured funding currency for carry traders exploiting yield differentials. Investors have borrowed plentiful funds at near-zero cost in the Tokyo market, sold the yen, and invested the proceeds in higher-yielding currencies such as the Australian and New Zealand dollars, and the euro.

Carry trades financed such huge asset acquisitions and put so much upward pressure on exchange rates of target countries that the Reserve Bank of New Zealand despatched an unusual mission to Japan last year to warn Japanese investors about the risks of carrying trading, talk down New Zealand's real estate market and try to stem the inflows.

One consequence of Japan's zero interest rate policy has been the leakage of plentiful liquidity abroad rather than to restart domestic lending.
The main danger with using the yen as the funding currency has always been its residual strength, unpredictable appreciation against the U.S. dollar, and resulting sharp swings in the crosses against other currencies.

Now that the Fed has matched the Bank of Japan in cutting rates to zero, there must be a risk the dollar will take over from the yen as the funding currency of choice, creating a persistent new source of dollar selling.

CHINA'S BOND HOLDINGS

While the dollar may become the darling of carry traders, the Fed's rate cuts and attempts to manipulate the shape of the yield curve would at first glance seem to have brought an early and unexpected Christmas present to the government in Beijing.

As the world's largest owner of U.S. Treasury bonds and mortgage-backed agency bonds, China's State Administration of Foreign Exchange (SAFE) is the largest beneficiary of the bull market in Treasury securities.

For years, China's leaders have worried their excessive concentration of reserve holdings in dollar-denominated bonds leaves the country vulnerable to a crisis of confidence in the dollar or a rise in yields triggered by concerns about inflation and debt issuance.

Persistent attempts to diversify have been stymied by fears of precipitating the very crisis of confidence, currency collapse and bond sell off China wants to avoid. China's massive stock of bonds is so large there is insufficient liquidity to sell it. Instead the bond mountain has overshadowed the whole market and made it almost impossible to withdraw.

Now the Fed has unexpectedly arranged the strongest bull market in U.S. Treasuries anyone can remember, China has been handed an unexpected capital gain - and a seemingly golden opportunity to start exiting by selling some of its Treasuries into the rally to investors clamouring to buy them.

The more the Fed drives up Treasury prices along the whole curve, the more tempting it will become for China to liquidate at least some of its bond mountain, pocket a tidy profit and reduce its excessive exposure to the United States.

Heightened risk that SAFE will begin selling bonds and repatriating the proceeds has intensified downward pressure on the U.S. currency.
However, this Christmas present is one that China many never be able to open.

In fact, equilibrium across the fixed-income and currency markets ensures the dollar will have to weaken enough to ensure exchange losses from converting the bonds to euros or yen offset any gains China could make from selling the Treasuries at inflated prices into the rally, and keep China's reserves remain safely locked up in U.S. government debt.

China had no way out when the Treasury market seemed at risk of an inflation-driven sell off. Now the dollar's sell off leaves it no way out when the market is rallying.