Despite a host of rational reasons for expecting a sustained sell-off in the dollar over the past six months (including a record trade deficit, surprisingly weak capital inflows into the US being recorded by the US Treasury, an increasingly dovish FOMC and concerns about the US housing market) the simple fact is that it has failed to emerge. Even the steady decline in long-term US yields and ever rising Fed Funds futures have failed to shake the greenback’s equanimity. One relevant measure of this is that one-month historical volatility of the dollar index has almost halved since 24 May this year and recently stood at its lowest level since the start of 2004. In fact, looking back over the past two decades, we can identify only six or seven occasions when the dollar index has been less volatile. What then can we surmise about the driving forces behind the dollar at present?
Looking at the greenback’s performance thus far in 2006, one thing seems to stand out: the only period when it showed a marked propensity to trend came between mid-April and mid-May as emerging equity markets and a wide range of commodities soared to major (often record) highs. During this one-month gap, the dollar index lost 6.3 per cent in relatively short order as investors flocked to these high performing markets. It is also noticeable, however, that since the emerging equity markets sell-off in mid-May, the dollar has failed to make any significant progress in either direction. Whatever volatility remained in the dollar index by early August appears to have been squeezed out subsequently as the commodity markets sell-off developed. This is most clearly illustrated by noting that the rapid decline in one-month historical volatility of the dollar index went hand-in-hand with a decline in the CRB commodities futures index from early August.
With this in mind, perhaps the simplest explanation for the dollar’s apparent robustness has been down to a change in attitude among international investors. It is particularly noticeable, for example, that a significant number of the Bank of New York’s iPFM charts have shown a marked slowdown in the pace of inflows into emerging equities since the May sell-off (Malaysia is the example provided above). Could it be that the relative strength of the greenback (in the face of some well know structural issues) is down to no more than a decline in the appetite of dollar-based investors for previously high performing markets elsewhere? In short, we wonder whether dollar stability has been a direct function of international investors sitting on their hands over the summer.
This, however, raises some interesting questions for the months ahead. In particular, it suggests that if levels of risk aversion rise from current levels (driven, for example, by events on the Korean peninsula or by signs of a global slowdown in growth) then international investors may decide to start actively reducing their positions in many of these previously favoured markets. Given the amount of money that has moved into such investments since the end of the Iraqi war, and considering the relative illiquidity of some of the smaller markets, the risk is that we could see the dollar stage a surprisingly robust revival (and help US asset markets outperform). Thus, although the dollar looks poorly positioned from a longer term perspective, we must also recognise that there is a very clear risk that a shorter-term revival in the dollars fortunes could emerge if global investors begin to take a more pessimistic view about the global outlook.
Neil Mellor is a currency strategist at the Bank of New York.
Researched and published in association with the Bank of New York.
