The Dollar As A Funding Currency

Nouriel Roubini is not a man who is known for mincing his words. “We
have the mother of all carry trades,” he tells us, “Everybody’s playing
the same game and this game is becoming dangerous.” There is a “wall of
liquidity” sweeping the planet, pushing asset prices ever higher in one
country after another. I wholeheartedly agree.

Investors across
the globe are taking advantage of the ultra low interest rates on offer
at the US Federal Reserve to borrow in dollars in order to buy assets
like government debt, equities and commodities, in the process, as
Nouriel says, fueling “substantial” booms that if not checked in time
may sow the seeds of yet another financial crisis. This is a classic
example of the so called “carry trade” in which investors borrow in
countries with low interest rates to invest in higher-yielding assets.

The
dollar has fallen by about 12 percent (in relation to a basket of six
major currencies) in the last year as the Federal Reserve has cut
interest rates to a record low of around zero in an effort to lift the
U.S. economy out of its worst recession since the 1930s. The problem is
that this has created what Professor Roubini rightly terms the mother
of all carry bets against the US dollar, and lead to all kinds of
speculation that we are at the dawn of a new era, one which will have
the “death of the dollar” as its defining characteristic, and where in
the dollar will no longer serve as the world’s reserve currency of
preference.

Well, as someone once said, rumours of my imminent
demise are somewhat exaggerated. The greenback is still alive and
kicking, and will be for many years to come, although we also need to
be realise that structural changes are underway. So
while in the short term we should not really be in doubt that the
decline in the dollar will eventually “bottom out” as the Euro-USD
crossover reaches ever more painful levels for the eurozone’s heavily
export dependent economies while the Fed will at some point begin to
hint that it is considering raising borrowing costs and start to with
draw some of the “quantitative easing type” stimulus measures,
including, of course, those large scale purchases of US government
debt. But this is not likely to happen rapidly, or in a disorderly
fashion, so in many ways investors will have time and space to
reorganise their betting card.

This was once more made plain
this week, when Federal Reserve decision makers signaled quite clearly
that a simple return to economic growth alone won’t justify higher
interest rates on their part, stressing that any future increase will
depend on the labour market and inflation trends, and indeed the Fed’s
rate-setting Open Market Committee resasserted its pledge to keep rates
“exceptionally low” for an “extended period.” Following these comments
traders began to pare back their bets that an increase in borrowing
costs will come in the first half of 2010, the dollar weakened and
short-term Treasury yields fell.

The impression that the Fed
will not be the first out of the box among the major central banks was
only reinforced today as the European Central Bank seems to have
hesitatingly taken its first step toward removing emergency stimulus
measures by indicating it won’t be continuing to provide commercial
banks (and of course the governments whose debt they are buying) with
the current 12-month loans as 2010 advances – although no timetable for
phasing them out has so far been provided. Nor has it been made plain
what structure will replace them. Jean Claude Trichet seems to have
contented himself with enigmatically teasing the assembled journalists
by stating “Not all our liquidity measures will be needed to the same
extent as in the past” and pointing out that since market sentiment
didn’t expect the ECB to prolong its offer of 12-month long term
funding beyond December he was going to “say nothing to dispel this
present sentiment.”

Assessing what exactly is happening here is
difficult, since in the world of central bankspeak it would be a
mistake to think that expressions mean what they actually normally mean
in everyday discourse. So it is not clear whether or not the strategy
between the Fed and the ECB is coordinated at this point or not, and if
it is, to what extent. Certainly despite Timothy Geithners insistence
on the US Treasury’s strong dollar policy, it is hard to imagine that
anyone (not even the Chinese) actually take him at face value here, and
indeed, if you read the reports carefully, Trichet is only complaining
about excessive volatility, and not about the level of the Euro in and
of itself. This impression, that those taking decisions accept that the
dollar needs to stay down to allow the US economy to correct itself is
only reiforced further by concerns expressed only today by Kenneth
Rogoff, Raghuram Rajan and Simon Johnson (all economists who have
previously worked for the IMF) as to whether the IMF and the G20
actually had the wherewithal to address the global imbalances problem.
It should not escape our notice that this “concern” was expressed just
one day before G-20 finance ministers and central bankers, including
U.S. Treasury Secretary Timothy Geithner and European Central Bank
President Jean-Claude Trichet, are to start two days of talks in St.
Andrews, Scotland.

In fact, there is some evidence of progress
being made, since the U.S. current account deficit narrowed in the
second quarter to its lowest since 2001, and I’m pretty sure a solid
majority of Europe’s leaders accept the need for the deficit to be
allowed to correct further if future growth is to be put on a more
solid footing.

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