America’s current account deficit has been expanding rapidly in recent years. While it ran at an average of $43.31bn (€36bn) per month in 2003, it expanded to $55.67bn a month in 2004 and so far this year is running at an astonishing $65.7bn a month. However, what may not be immediately realised is that this has done little to dent the appetite of foreigners for US assets. The TICs data provided by the US Treasury indicate that foreigners have been heavy buyers of US assets over the past three years. In 2003, net purchases (foreign purchases of US assets less US purchases of foreign assets) averaged $55.27 bn per month compared to $63.63bn in 2004 and $75.17bn so far this year. Even if net foreign direct investment outflows from the US are subtracted from these totals ($6.1bn in 2003 and $12.1bn in 2004), net inflows have still been substantial.
In view of the fact that US-bound investment flows exceeded the country’s external funding requirements in 2003/2004, why was this not reflected in the performance of the dollar? Moreover, why do these net inflows appear to have provided support for the dollar in 2005, when the US current account deficit grew even wider? The answer, not surprisingly, appears to lie in the costs of FX hedging. We believe that the critical change for the currency markets this year has been that it has become uneconomical for many foreign investors to hedge the currency risk on the US bonds they have purchased. This can probably be best illustrated by considering what has happened to dollar/yen.
Prior to the US Federal Reserve’s sustained rate hike strategy (which began in June 2004), capital inflows into Japan’s equity markets would most certainly have carried the yen higher. However, with the yield gap between Japan and the US at the shorter end of the curve rising this year to levels far in excess of the pick-up available in yield from owning US Treasuries over JGBs (the one-year gap now stands at 466 basis points in favour of the US compared to a 301 basis point pick up on 10-year US Treasuries over JGBs), there has no longer been any incentive for Japanese investors to purchase currency hedged US bonds. Accordingly, this group has increasingly embraced currency exposure as 2005 has progressed. This, in turn has allowed the dollar to rise steadily as the currency impact of the outflows increasingly exceeded that of the inflows. Total average weekly capital outflows from Japan have exceeded capital inflows by a ratio of 3/2 so far this year while there has been an 88 per cent correlation so far this year between the price action in dollar/yen and the cumulative purchases of foreign bonds by Japanese investors.
Critically, the same basic equation is also true when comparing the euro-zone to the US. Here again the one-year yield gap between the US and the euro-zone stands at a far higher level than the pick up in yield from owning 10-year US Treasuries over Bonds, highlighting that the cost to Euro-zone investors of buying US paper on a hedged basis has also become prohibitive.
Given that the growing cost to foreign investors of hedging currency exposure from US fixed income purchases has come at a time when the demand from overseas for these instruments has soared, it is perhaps not that surprising that the dollar has enjoyed the support that it has. This also suggests that as long as foreigners continue to flock to the US bond market and the cost of hedging remains prohibitive, then the dollar should remain well supported.
Neil Mellor is a currency strategist at the Bank of New York.
Researched and published in association with The Bank of New York.
