[AndrewWoo]

USD – This safe haven is about as safe as houses….and we all know what happened to US house prices

The US economy and its markets are still dogged by some of the weakest fundamentals one could reasonably expect for the biggest economy in the world.

This makes the USD mini-rebound in recent days at least a little problematic. Arguably, it is an opportunity to establish short USD positions and then wait for the depreciation of the USD to unfold as these dismal fundamentals continue to
impact. The USD gains of the last week or so appear to be based on the market reassessing the risk trades or the global recovery scenario that was recently a very popular notion. The recovery, it is increasingly clear, was based on hope and a rose-coloured assessment of a few less-bad economic releases.

The current market mantra is that the USD rallies in times of heightened economic and market adversity and falls when investors plonk their money into what are considered risky assets and markets. The thinking behind this market behaviour is linked to an elevated demand for liquidity and transparency during troubled times. Of note, this type of market move has tended to work during past crises.

There is no doubt that, for the moment at least, the relationship between greater risk and a stronger USD (and vice versa) exists. Using stocks as a proxy for market risk appetite, the link between the two is clear. In the past few days, stock prices have tended to be weaker and simultaneously, the USD has rallied. During the increase in risk appetite a few weeks back, the USD fell sharply while stocks, and perceived ‘risky’ assets, rallied.

Perhaps in the old days, when a crisis in Latin America or Asia, heightened geopolitical tensions, stock market collapse or a similar amount of upheaval saw the USD strengthen on as a safe haven trade, there may have been some substance to this relationship. At this time, the fundamental position of the US economy was sound and the robustness of its markets and policy flexibility was unquestioned. This was because the position of the US economy was unambiguously strong.

It needs to be noted that this dominant position of the US is fading. The changes are sufficiently momentous as to raise serious questions about the current USD rally / safe haven trade. What’s even more important, many of the global problems were started in the US economy, markets and policy settings and as such, the US should not be the safe haven it is perceived to be. Blindly ploughing into USD in times of risk aversion when it is the US economy and markets that are the epicentre of the problem is fraught with risks.

This time around, the ratings agencies are on the case. Earlier this week, Moody’s were reported as saying that the US government’s AAA credit rating “could be at risk” if the government were unable to bring public sector debt “back to a downward trajectory” and that the AAA rating “was not guaranteed forever.” This is clear with the budget deficit exceeding 13% of GDP, government debt surging to historical highs and the economy still mired in recession. The rating agencies have, in the past, taken a dim view of countries with fiscal positions less extreme than those currently prevailing in the US. We wouldn’t think a ratings downgrade for the US is on the cards – the US is “too big to fail”.

If these obvious concerns are overlaid with the massive problems with the Budget position of many State governments (California is on the edge of a fiscal catastrophe) then the reasons for viewing the USD as a safe haven are open to question. As a share of GDP, the State and local government sector deficit is now at a record of around 3% of GDP. This makes the US more risky as the fiscal deterioration is in stark contrast to the small surpluses / approximate balance in the sector over the past 40 years or so.

The level of debt and the additional risk associated with it is further reinforced by the fact that US savings remain low. In other words, the US is very dependant on foreign savings. At a time when there is huge demand for global savings from
all other governments running large fiscal deficits, the USD is likely to be the safety valve that allows the US deficit to be funded.

If not, the US could have difficulty funding its deficit leaving open the prospects of a large USD correction – lower. The USD as a safe-haven looks an old-fashioned argument. In the near term, it might be difficult to fight the thinking that sees the USD rally in troubling times. But some are confident that if not today, that over the next year or so, the USD will resumes a path of depreciation and that diversification might be the new safe haven.