US Dollar in 2010

Survey shows that the USD was named as both investors’ second favourite and second least favourite currency heading into 2010. Since hitting a 16-month low on a trade-weighted basis at end of November 2009, the USD has risen more than 5% given its strong correlation with risky assets such as equities are showing signs of breaking down.

Investors are split as to whether the resurgence reflects a squaring up of bets against the dollar ahead of the end of 2009 or whether it is the start of a longer-term upward trend in the US currency. The fragile finances of Britain, Japan, Russia, Spain, Ukraine and other nations increasing the chances of a scary market event that the assumption of the dollar’s straight line decline is no longer a given.

Low short-term interest rates in the US encouraged asset re-allocation with the US dollar being used as a funding currency for carry trades, thus undermining the currency’s strength. But this situation is balanced up with the view that the recovery in the US economy is gaining momentum and should it proved to be sustainable, this will help to ensure that capital flows become more balanced and thereby less dollar-negative.

Volatility of the dollar is increasing and there is broad consensus in the market that the dollar will rally once the Fed signals that it is ready to drop its pledge to keep US interest rates at ultra-low levels for an ‘extended period’. It is just the timing of such a move that is polarizing views on the currency.

Investors are now looking for signs for shifts in correlation which may signal the end of the US as a pure safe-haven play and becomes a value proposition instead. A full shift perhaps may still take months away, but the relationship between the dollar and stocks and commodities has weakened in November 2009. Two key indicators to watch – the sustainability of economic growth and build up in inflationary pressure, which would lead to higher interest rates, hence would undermine the dollar’s role as a borrowing currency of choice.

History, however tells us the US dollar shouldn’t start rising on a sustainable basis until 12 months after the Fed starts to lift rate. It will take time to drain the oversupply of dollars from the market and the currency will remain weak until the Fed’s rate rises above the competitors. After policy makers started boosting borrowing rates in July 2004, the dollar index tumbled 10% and didn’t get back to where it had been before the first increase and stay there for more than a month until November 2005. Intercontinental Exchange Inc’s dollar gauge fell 6% and took 7 months to recover after the Fed began lifting borrowing costs in July 1999. It dropped 16% following the Fed’s 1994 move without regaining lost ground until 1997.