According to Morgan Stanley, a sharp rise in the dollar will be ignited when foreign private investors return to the USD in force. Exponentially rising currency reserves from emerging market central banks have absorbed dollars from the private sector, effectively leaving that segment of the market net short, says Hans Redeker, global head of FX research at Morgan Stanley.
He argues that although reserve manager activity from central banks such as China and Brazil reinforces currency trends once they have begun, it is private flows that determine those trends. The behaviour of this segment is therefore of greatest importance for the direction of currencies.
Bank for International Settlements statistics also show that US lending to foreign entities has increased since the crisis, which is typically correlated with USD weakness.
“When there is US lending to entities abroad, the private-sector USD short position seems to increase and when lending falls, the opposite happens,” says Redeker.
“The lending to outside entities has reached $5.8 trillion, which compares with $2 trillion to the private sector. If risk aversion continues to rise and this lending is cut back, we would expect the USD to rally.”
 |
| Source: Morgan Stanley |
Furthermore, the current private-sector USD short position could push the USD higher should investors conclude that investments in the US offer a better risk-reward opportunity than the foreign investments they currently hold. As investment to GDP ratios in emerging economies rise, marginal productivity rates will be expected to fall and, subsequently, the attractiveness of these destinations for foreign investors is expected to decline.
“The privately held global USD short position could then lead to pronounced USD buying when investment themes change,” says Redeker.
When these themes emerge, central bank reserve managers would be expected to reinforce the upward movement of the dollar, if a clear trend in the currency market were to emerge.