[cppene]

There was hand over fist buying of USD is a stark change of fortunes for the currency which most investors loved to hate not 3 months ago. It was first the possibility of higher long-term US yields as a consequence of the pullback in liquidity measures by the Fed that started the USD rally. The most recent leg higher for the USD has been the possibility of a pullback in lending in another important economy – China – that has investors buying back the greenback. Before we explore the possible reasons why the USD is back in favor, let us review what has transpired overnight.

China’s Q4 GDP growth (10.7% y/y) and 2009 annual GDP (8.7%) came in broadly in line with expectations but CPI inflation was stronger than the market expectation at 1.9%., with food inflation reported to have added 1.7pp to this annual rate. In view of the recent strong data releases and a reported sharp rise in new lending at the beginning of the year, analysts believe controlling the pace of credit growth will be the key objective for monetary policy in the next few months. Market also maintains the view of a moderate appreciation of CNY vs USD by up to 5% in 2010, but the timing of a break from the current range in USD/CNY looks highly uncertain.

Why is this positive for the USD? Some of the possible candidates: 1) Worries about global growth: The safe-haven qualities of the USD means that it does better when worries about global growth arise; 2) Pullback in liquidity: USD is a favored funding currency for many risky assets and so benefits when liquidity declines; and 3) Reserve accumulation and diversification - the possibility of modest appreciation of CNY increases the likelihood that other EM currencies, especially those in Asia, will be allowed to appreciate. This would reduce the scale of reserve accumulation by EM central banks and as a result reserve diversification as well. Further, a USD that appreciates versus the other major currencies reduces the pressure on reserve diversification