[LFX]

In recent times, the market has slavishly followed a phenomenon where a rise in so-called risk aversion has been associated with USD strength and vice versa with a move towards more risky investments linked to USD weakness. In terms of the US economy itself, this has shown up in the form of ‘bad’ economic news being associated with USD strength and ‘good’ economic news with USD weakness.

This is perhaps best shown in the correlation between US share prices (as a proxy for risk appetite) and the USD index. In the last year or so, but certainly since the start of the economic and financial crisis, most moves in share prices has been matched by an opposite move in the USD.

This FX market phenomenon does not apply to any other countries when bad domestic economic news is associated with currency weakness and vice versa. Note some recent trends in the UK, for example, where bad news has seen the
GBP fall and good news in Australia has seen the AUD rise. This is how a system of floating exchange rates should respond.

The issue of the USD appearing to trade perversely to fundamentals raises a number of questions. One is whether this will change at some stage – perhaps when the US economy unambiguously improves – or whether in fact the phenomenon is a function of the USD being the world’s reserve currency, or even whether there are other reasons explaining the USD movements.

Markets can over-shoot and stay well away from fundamentals for expended periods, but ultimately, the value that matter), must be based on something substantial. This is why the current method of trading the USD may start to break down at some stage. The current fashion of selling the USD on good news and vice versa is not sustainable over the longer run. One thought is that once markets settle down from the ructions of the global financial crisis and the world
economy enters a sustainable expansion, the focus on USD fundamentals is likely to return.

Looking at the longer run link between risk and the USD (the same chart as above but over the past 15 years) and it is clear that the link does not hold. A booming stock market from about 1995 to 2000 was associated with USD strength.

[LFX]

Importantly, the current relationships between risk and the USD appear to be broadly linked to the perceived virtue of the USD as liquid and safe and as a barometer of possible ‘excess returns’, both positive and negative, in a climate of
renewed favourable economic activity. It has generally been a very successful trading strategy to take positions in the USD based on risk.

There is also the case that what happens in the US is critically important for the rest of the world and market. This may seem obvious with the US still accounting for more than one-fifth of world GDP, but when the US slid into the deep recession, it meant the prospects for the rest of the world deteriorated. There was no decoupling here, just a lag. Because of the dominance of the US in the world economy and markets, the trade was to sell other currencies as their economies were dragged into the mired generated by the US economic misery. The opposite is true too that in a climate of, for example, an unexpectedly powerful recovery in the US, “buy the rest of the world” will be valid as the dynamism of a strong US lifts the rest of the world with it.

This story can only go so far. If the US has genuinely great fundamentals at some stage, the USD should and will appreciate. Think of the US with strong growth, fiscal surpluses and high real yields. While the world would also be strong, these dynamics would surely favour a stronger USD and we only need to look back at the second half of the 1990s to see strong growth, high yields and fiscal surpluses for an example where fundamentals do work – as mentioned, this was a period of unrelenting USD strength.

But let’s have a look at the past 12 months or so. The fall in the USD since the worst of the global crisis has passed may actually be masking something else – the economic fundamentals of the US economy and its currency might just actually demand a lower USD! It may have little to do with risk appetite. If so, this may show that the market mantra about trading the USD on the back of changes in risk aversion may be at least a little misguided.

[LFX]

The US has many characteristics that demand a lower USD. Its recession has been about as bad if not worse than most other countries thereby reducing any growth impetus to the USD. At the same time, the deterioration in the budget
balance has been one of the most severe in the world which in itself it an important negative influence on the USD.

Linked to that is the fact that the US is so very heavily dependent on foreign savings to fund its budget that the bigger deficit has meant the USD has had to weaken to attract fresh inflows. This is in stark contrast to Japan, for example, where similarly horrendous public finances has had little JPY impact because the vast bulk of the budget deficit is financed from domestic sources. With domestic
savings in the US still very low, even allowing for the rise in private sector savings with the recession, it seems that the US will still require the rest of the world to fund around half of its new bond issuance over the next few years.

At the same time, the current account deficit remains chunky, at around 3% of GDP. While this is nicely lower than the peak levels for the deficit around 6% of GDP just a year or two ago, it is high when compared with many other regions.

All of the above, plus the super stimulatory stance of policy from the Fed, show clearly USD weakness is fully justified. When the US economy does eventually start to exhibit some sustained positive trends into 2010 and 2011 – perhaps GDP growth locking in a 2.5%+ momentum, if there is a surprise narrowing in the trade and current account deficits and if the budget deficit and bond issuance task narrows as the economy recovers, the USD could well start to move higher. It should.

In the near term and until there is a broader type of global economic pick up and a return to some form of normalcy in markets, policy and economy performance, it is still seems wise to trade the USD according to market risk assessments. This fashion will not last forever and once foreign exchange markets focus more on fundamentals, the is scope for the USD to find favour.