USD revival has further to run as reserve accumulation slows, says Morgan Stanley

Since the beginning of August, with the exception of the yen, G10 currencies have lost an average of 3% against the dollar, if the 9% drop in the value of the Swiss franc as a result of the currency floor is taken into account. In relation to the Asian currencies, where reserve managers have been some of the biggest diversifiers, they have lost on average 4%, excluding the renminbi and the Hong Kong dollar.

While today’s TIC data show that Chinese and Japanese holdings of US treasuries increased in July, Morgan Stanley warns that they need to be considered in context with overall global FX reserve accumulation. In its own analysis, Morgan Stanley argues that reserve accumulation will slow as a result of cyclical developments. They cite China as an example.

“We would argue that this is not necessarily a negative for the US dollar,“ says Ian Stannard, head of European FX strategy at Morgan Stanley. “Indeed, this is likely a reflection of slowing incoming US dollars to reserve managers, suggesting that diversification will also be run at a reduced pace, leaving the alternative reserve currencies, especially the euro, vulnerable.”

Those reduced dollar receipts are probably a result of changing macroeconomic trends stemming from the increased likelihood of a global slowdown, argues Morgan Stanley. “Many of the currencies that have been supported by the diversification process will see central bank demand fall, exposing them to negative fundamentals, whereas the dollar, which has been depressed through central bank selling, is now likely to see some relief,” says Stannard.

The recent weakness in the euro has shown a relatively close relationship to changes in the relative size of Federal Reserve and European Central Bank balance sheets and expansion in the ECB’s balance sheet relative to the Fed’s should see EURUSD come under pressure. The ECB’s balance sheet is set to expand as the central bank continues with its bond support programme, buying up eurozone periphery debt, whereas discussion in the US at this stage seems to be more in favour of portfolio adjustment to extend the average duration of securities on the Fed’s balance sheet, rather than engage in quantitative easing to directly expand its balance sheet.

If the Fed does implement so-called Operation Twist, raising short-term interest rates and lower long-term yields the lower spread between US short-term rates and the rest of the G10 and will also likely have a dollar-positive effect.

Stannard also explains that the latest European balance of payments data is an additional factor behind their particularly bearish euro stance. Up until now inflows have been substantial but the most recent European balance of payments data shows that the trend has been reversed and net foreign inflows have turned negative for the first time since January.

“The latest data shows that foreign investor inflows into European asset markets have not only now started to decline but that we are starting to see an outflow taking place. This points to the fact that we are seeing a change in the global dynamics in currency markets which is going to be a big negative factor for the euro” says Stannard