FX Focus – The Pinnacle of USD Rally

The USD index has experienced its largest quarterly rally in more than 15 years. One of the earliest sources of support for USD seems to come from rising tensions in the money markets, seen in the level posted by the three month USD LIBOR-OIS spread on the back of severe lack of USD liquidity. Now with global central banks continue to ease tensions in the money markets, this has largely removed this source of support for USD.

However, the expected USD retracement was largely prevented by repatriation bid created by the sharp declines in global equity markets. If the repatriation of foreign investments to the United States is slowing down, then this source of support may also be coming to an end. TrimTabs reports that American mutual funds that invest primarily in non-US equities returned nearly US$66bn in capital from late August to mid November, but these flows are easing with the two-week moving average is pointing south.

The sharper decline in the yields in non-US also contributed to this momentum as the long end 10-year Bund has plunged 93bps versus the 27bps drop in US 10-year Treasuries on the back of increased expectations for monetary easing in the Eurozone and a flight to quality bid.

Now, it seems that the ability of USD to post further gains appears to be limited. That, in turn, will make valuations in emerging markets are cheap and December could offer an interesting entry point due to pattern of seasonal weakness normally seen in year-end for USD. A meaningful rally for EM currencies is unlikely before year-end given the substantial deterioration in the international financial crisis could readily push the real effective exchange rate lower.