Forex Investment and Currency Trading

Despite the US being at the epicentre of the current market turmoil, USD has remained remarkably robust in recent sessions. Indeed, many periods of acute equity market stress recently have been associated with USD strength. On the face of it, this is baffling as USD has all the attributes of a risky asset rather than a safe haven. The US’ large budget and current account deficits and status as a net debtor leave the currency subject to vagaries of volatile capital flows and vulnerable to the tendency for capital to flow home at times of financial stress.

So, what explains USD’s apparent status as a safe haven and more importantly will it continue? The answers probably lie in the detail of the external accounts rather than the headline deficit. Changes in FDI assets and liabilities have been broadly offsetting and the same is true in “other” (largely short term) flows. But there has been a huge change in the US’ external position in bonds and equities. The USD4.9trn spike in bond liabilities is, of course, the counterpart to sustained US budget deficits on the one hand and the accumulation of global central bank reserves on the other. It is no coincidence that IMF data show total global FX reserves rising by a similarly large USD5.0trn over the same period.

It is the asset side of the US balance sheet, however, that perhaps explains recent USD robustness. Whilst the US’ external debt liabilities have exploded in recent years, there has been an almost equally large jump in equity assets. Overseas equities held by the US have jumped by USD3.3trn over the same period with only a small (USD1.3trn) offsetting rise in liabilities.
The extraordinary appetite for overseas stocks on the part of US investors is confirmed at the micro level by mutual fund flows.The dichotomy between demand for non-US equity funds and US funds is striking. Since 2004, inflows into non-US equity mutual funds have amounted to USD229bn, while investors have been net sellers (USD23bn) of domestic stock funds.

Although the US has slipped ever deeper into external indebtedness in recent years, this debt is largely in the hands of “buy and hold” central banks. At the same time, relatively fickle equity (particularly retail) investors have been piling into overseas markets.

Repatriation driving USD demand

At least in part, recent USD strength reflects repatriation into USD as these flows go sharply into reverse. According to the Trimtabs data, there was a net outflow from foreign mutual funds in the week ended September 10, the largest net outflow this year. So long as financial stresses persist, these repatriation flows are likely to continue, leaving domestic US investors significant buyers of USD. There is a great potential there for repatriation support for USD in coming weeks.

Although this has been a major prop for USD through the current crisis, ironically, it also highlights one of USD’s key vulnerabilities. As today’s equity market bounce/USD weakness following central bank liquidity injections highlights, any sense that the current financial crisis is coming to an end (a distant prospect currently) is likely to see USD sold aggressively. For the time being, however, the intuitive reaction to waves of financial stress – sell USD – is likely to be the wrong one, with carry and relative liquidity likely to remain the more important determinants of returns.