[Pimpllus]

From Q3-2008, the US dollar (USD) benefitted from the global recession, investor repatriation, deleveraging, and a focus on negative surprises outside the US, notably in Europe and Asia. However, some market analysts believe the Fed’s aggressive quantitative easing policy has fundamentally changed the game. On 18March, the Fed announced major additional purchases of securities to its existing balance sheet. The Fed decided to purchase up to an additional USD 750bn of agency mortgage-backed securities and increase its purchases of agency debt this year by up to USD 100bn. In addition, it decided to purchase up to USD 300bn of longer-term Treasury securities over the next six months. The Fed followed in the footsteps of the Bank of England (BoE), Swiss National Bank (SNB), and the Bank of Japan (BoJ), which have also announced quantitative easing measures. However, the Fed’s measures are the most aggressive. In the near term, the ECB could begin to purchase private-sector debt such as commercial paper and corporate debt to improve corporate funding and encourage banks to boost lending. However, the ECB is not allowed to finance Eurozone governments, so directly purchasing government bonds, as the Fed has done, is not an option.

Some analysts see the US quantitative easing policy as fundamentally bearish for the USD, as it raises the concern that the US is monetising its fiscal deficit. Data from the Treasury International Capital System (TICS) indicates that foreigners
are gradually losing their appetite for US financial assets. Since the credit crisis unfolded in July 2007, foreign net buying of US long-term securities has dropped on a trend basis. The key factors have been a significant drop in foreign net buying of US Treasury bonds and notes and of US government agency bonds.

Some may argue that the US will have less need for foreign capital inflows going forward as US consumers save more and spend less, leading to an improvement in its external balances. The Q4-2008 US current account (C/A) deficit narrowed to -USD 132.82bn from -USD 181.30bn in Q3. The deficit narrowed to 3.74% of GDP in Q4-2008 from 6.56% in Q4-2005. The improvement in the C/A balance reflects sharply reduced bilateral trade deficits with major trading partners such as the OPEC countries, Japan, and the Eurozone. Going forward, the C/A deficit is
likely to narrow further on a trend basis given the relatively high contribution of domestic demand to US GDP growth compared to major trading partners and the deep recession. However, some analysts expect the US budget deficit to widen to
13% of GDP for the current fiscal year and to 8% for the fiscal year starting in October. This is much larger than the deficits in other major economies, such as the Eurozone. Some believe the sharp rise in the US fiscal deficit will outweigh the narrowing of the C/A deficit, and hence that the US will need more, not less, capital inflows in coming years.

Near-term, the USD will continue to get fundamental support from the global recession, investor repatriation, and ongoing deleveraging. The global economy is still in the midst of a recession, and global deleveraging continues. However, some market experts expect the USD to fall off a cliff in H2, when global growth expectations bottom out. At that time, the FX market will likely refocus on poor US fundamentals, including the widening fiscal deficit, zero interest rates, and very weak growth prospects. US investors who have taken money home over the last year will likely begin to invest abroad as they did during the boom years from 2003-07. This will resemble the 2001-02 period, when the USD remained strong during the US recession in 2001 but began its multi-year downtrend when US and global economic expectations bottomed out at the end of 2001.