Dollar shedding its funding currency status


Peter Garnham
Published on:

The strength in the dollar after Wednesday’s robust US retail sales data highlights the shift in the foreign exchange market that has seen the US currency shed its mantle as the funding currency of choice in the first few months of this year.

Put simply, with the S&P 500 trading at a five-and-a-half-year high and the dollar index at a seven-month high, the US currency no longer appears to have a negative correlation with stocks.

Indeed, the dollar has now reacted positively to a string of recent good US economic data, and is exhibiting a positive correlation with stocks for the first time in years.

 Correlation between dollar index and S&P 500

The change in behaviour is quite stark, given that investors were only too happy in recent years to sell the low-yielding dollar in times of rising risk appetite to fund the purchase of higher-yielding assets elsewhere.

Monetary policy in the US, of course, remains ultra-loose, with the Federal Reserve engaged in QE3 and promising to keep rates at “exceptionally low” levels.

However, it appears that with the US economy outperforming the eurozone, Japan and UK, investors are more reluctant to use the dollar as a funding currency.

 Correlation between USD/G10 FX rates and S&P 500

Indeed, as the chart above shows, as expectations for further monetary loosening in struggling countries such as Japan and the UK have risen, so other currencies have displayed the dollar’s traditional negative correlation with stocks.

“Fed QE3 is huge, but well-established,” says Tom Levinson, FX strategist at ING. “But the establishment of innovative, new easing from the Bank of Japan and the Bank of England means the dollar faces genuine rivalry for its chief funding currency status.”

In other words, currencies of countries in which monetary policy is under review, such as the pound and yen, and also the Canadian dollar – given that the Bank of Canada has loosened its tightening bias in recent meetings – have been the preferred carry trade vehicles in recent months.

Of course, that trend need not continue. The dollar, after all, will be vulnerable if Ben Bernanke, Fed chairman, chooses to reinforce his dovish view at the press conference after next week’s Federal Open Market Committee meeting. That could provide support for global risk appetite, but also encourage investors to fund positions in dollars.

Overall, however, the transformation of the dollar from funding currency to growth currency will depend on the relative health of the US economy.

Neil Mellor, strategist at Bank of New York Mellon, says while the dollar might be shedding its ugly status despite a regime of low interest rates, the US fiscal cliff remains a potential thorn in the side of any upbeat forecasts for the dollar.

“US congressmen are still at odds on how to tackle the deficit and there is still the risk that they will get it very wrong,” he says.

However, for those concerned that a lot of the good news surrounding the dollar is already priced in, flow data from Bank of New York Mellon – the world’s largest custodian bank – show that while asset managers have been solid buyers of treasuries in recent months, they are only now actively buying the dollar itself.

“We cannot help but feel that the dollar, cheap from an historical perspective, is also increasingly a no-brainer in a market devoid of obvious choices,” says Mellor.

“All dollar bulls need ideally is some reassurance from Congress that the recovery is in safe hands.”

If US policymakers can strike the right balance on the deficit, and safeguard the economy’s momentum, the dollar could truly shed its funding currency status.