[LehmanBr]

The dollar has begun to dip again on the world’s foreign exchange markets, drawing the attention of investors. Various arguments are put forth to explain the dollar’s weakness. These include excessive Fed money printing, increased inflation risk, large US budget deficits, doubts about sustainability of the US recovery, and dollar overvaluation. While many of these factors might eventually push the dollar lower, none provides a convincing explanation for dollar weakness in 2009. Instead, dollar weakness reflects declining risk aversion (and hence reduced demand for US dollar liquidity) and, possibly, increased ‘carry’ activity funded in dollars. Moreover, growth has surprisingly resurfaced in Europe and Japan ahead of the US. Finally, investors may be (correctly) anticipating that the decline in the US trade deficit is over.

[LehmanBr]

The Fed is printing too much money. So long as bank lending remains anaemic, the expansion of the Fed’s balance sheet is having little impact on the supply of dollars in the broader economy or financial markets, including the foreign exchange market. To the point, rate of total bank credit growth continues to decelerate. In short, the Fed has created plenty of ‘high-powered money’, but it largely sits idle on bank balance sheets and is having little direct impact on economic activity or most asset prices, including currency values.

The US is faced with resurgent inflation. Fears of high inflation would be negative for the dollar. However, near- and long-term inflation expectations are well-behaved and provide little evidence to suggest that investors are fretting about price pressures in the US economy.

Investors are worried about US budget deficits. Large budget deficits, if left unaddressed, would pose significant challenges for the US dollar. But presumably they would be even more problematic for the US Treasury market. Yet with bond yields low, it appears that investors are—for now— not concerned about US government financing risk.

The US is in the midst of a ‘false’ recovery. If US growth were expected to falter, the dollar would probably weaken in the currency markets. Yet if that were the consensus expectation among investors, equity and credit markets would also be giving up ground. Their ongoing strength, in contrast, suggests that growth expectations, per se, are not the source of recent dollar softness.

[LehmanBr]

However, the drivers of recent dollar weakness lie elsewhere.

One factor that helps to explain the dollar’s softness this year is the resumption of more normal risk-seeking behaviour in the capital markets.

These relationships require some elaboration. While the dollar has often been viewed as a ‘safe haven’ currency, its performance over the past year— strengthening sharply just as the US financial system and economy were on the verge of imploding—seems odd. However, during the extraordinary stresses of last autumn, investors prized liquidity above all else. And no currency (or capital market) can match the liquidity found in the US.

Hence, receding demand for liquidity this year as the financial system has stabilized helps to explain the dollar’s decline, coincident with the recovery of markets (falling equity risk premiums) and the normalization of risk indicators. Yet these relationships may also embed more than just a normalization of risk appetite. If investors are now genuinely seeking higher returns, the low interest rate environment provided by the Fed may be contributing to dollar weakness via ‘carry’. In other words, expectations of low and stable funding costs may be encouraging some investors to borrow in US dollars to invest in various assets, including foreign currencies and equities (e.g., emerging equities). In this sense, ‘carry’ is different from the usual interest differential approach to currency modelling. After all, interest differentials (short- or long-term) do not appear to explain very well the dollar’s movements against the euro in recent years.

Finally, the US dollar may also softening on expectations that the improvement in the US trade and current account deficits witnessed thus far in the cycle is now coming to an end. Indeed, last month’s sharp widening of the US merchandise trade deficit likely marks the turning point for the US external accounts. Why? Because the US external position was undoubtedly flattered over the past eighteen months by recession-induced import weakness, as well as by last year’s sharp fall in energy prices. A collapse of inventories, in particular, contributed to sharp fall in imports. As the inventory liquidation cycle concludes, so too will the fall in imports. The implication: A bigger US trade deficit is on the way.

So, as US growth and final demand now begin to normalize (note the sharp jump in August US retail sales), imports are likely to pick up again. To be sure, US export growth will benefit from similar developments overseas. However, a large initial trade deficit (meaning exports must grow faster than imports to close the gap) and a higher propensity of the US to import than in its trading partners suggests the return to ever-widening US trade and current account deficits over the next few years.