Other Factors Driving Dollar Weakness besides Dollar-Funded Carry Trades
There has been a lot of focus recently on the extent of Dollar-funded carry trades contributing to the decline in the USD. The IMF in a report prepared for the recently
concluded G-20 Finance minister’s meeting cited ‘In addition to foreign funds moving into emerging market equities, led by expectations of higher growth, there are indications that the U.S. dollar is now serving as the funding currency for carry trades. These trades may be contributing to upward pressure on the Euro and some emerging economy currencies.’ There are carry trades funded in USD and some analysts have expressed their worries over a new ‘carry bubble’ emerging.
The Dollar's decline so far does not seem too out of line, especially when you consider that the US is still cyclically one of the weakest economies around.
While there has been a pick-up in investment in higher yielding currencies and assets, there is a distinction to be made between speculative carry trades and investments made on the basis of stronger EM fundamentals. It is hard to draw the line where investment activity becomes a speculative bubble but we are not in the midst of a 'carry bubble' at the moment. Yes, inflows into EM assets have accelerated rapidly over the last several months but this has also arguably been led by improving fundamentals in these countries in general. US equity fund flows into EM markets have broadly tracked the widening growth gap between EM countries and the US.
Other factors underpinning Dollar weakness include hedging asymmetries. In a nutshell, this refers to the likelihood that overseas investors in US assets appear to be FX hedged to a greater degree than US investors of foreign assets. As a result, a rally in risky assets tends to result in Dollar selling to maintain hedge ratios.
Finally, part of the Dollar weakness trend observed so far since the crisis has also been due to the ongoing normalization in markets. This has been well described in a recent speech by Chairman Bernanke: ‘When financial stresses were most pronounced, a flight to the deepest and most liquid capital markets resulted in a marked increase in the dollar. More recently, as financial market functioning has improved and global economic activity has stabilized, these safe haven flows have abated, and the dollar has accordingly retraced its gains.’
|
Linear Mode
