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The famous image of three wise monkeys at the Tosho-gu Shinto shrine in Nikko, Japan, could have provided the inspiration for the G20 meeting in Pittsburgh last month. The carving is a representation of the proverb "see no evil, hear no evil and speak no evil". By adhering to this principle the G20 communiqué is a classic of its genre. Across 20 pages vague promises jostle for space with pious platitudes and rhetorical commitments. As is always the case, what is not said is more important than what is. In spite of the communiqué pointing out the importance of avoiding "unsustainable global imbalances", foreign exchange rates were not mentioned once. The G20’s speak-no-evil policy no doubt serves diplomacy well. But it is odd given that overvalued and undervalued currencies are the bastard child of imbalances and odder still when European Central Bank president Jean-Claude Trichet and the French and Japanese finance ministers are all too willing to spout their views on foreign exchange markets to the wires.
Actions speak louder than words. Last month China began a year-long programme whereby it will purchase $50 billion in bonds from the IMF, denominated in the arcane currency of the fund, the Special Drawing Right. This is not a short-term tactical bet against the dollar. Weighed against China’s $1.7 trillion of dollar-denominated foreign exchange reserves, it amounts to a droplet in the ocean. What it does signal, however, is a strategic desire to diversify and to challenge the dollar’s role as the world’s pre-eminent reserve currency.
With the DXY (dollar) index falling to levels last seen before the collapse of Lehman Brothers in October 2008, dollar bears are once more on the prowl. The militant tendency of this bitter band can be found all over the blogosphere. They rail against quantitative easing as Weimar Republic-style currency debasement. For them gold is the only store of value, other than guns, dried goods and bottled water.
| The most plausible explanation for dollar weakness is shifting risk appetite |
But even beyond the lunatic fringe the dollar is under scrutiny. Institutional investors have turned their backs on the currency. State Street Global Markets’ FX flow indicator shows that at the beginning of September monthly cross-border inflows into the dollar were in the 81st percentile of their past history (flows higher on only 19% of prior monthly periods over the past 12 years). They have since fallen precipitously to the 28th percentile. This dramatic volte-face mirrors the view of speculative investors who hold the biggest dollar short for 18 months. The most plausible explanation for dollar weakness is shifting risk appetite. The recent peak in the DXY index was on March 9. This coincided to the day with the trough of the S&P500 index. Since then, global equities have risen 67% and the DXY index has fallen 14.6%. This makes intuitive sense. The dollar rose 25% between April 2008 and March 2009, with most of those gains coming in the period of extreme risk aversion following Lehman’s demise. Institutional investors crowded into liquid, safe-haven assets.
This binary approach, risk off (buy dollars)/risk on (sell dollars), did characterize investor behaviour at the start of the rally. Throughout April and May institutional investors were net sellers of dollars. However, they returned to dollar buying in the summer and have only just begun to sell dollars aggressively in the past few weeks.
This is a far more nuanced approach than a crude risk on/risk off trade. The missing part of the story is probably provided by positioning. At State Street Global Markets our proxy for positioning is 120-day FX flows. At the start of the rally institutional investors had built a long position in dollars. In mid-March 120-day FX flows were in the 84th percentile of their history. By late June investors were short dollars (120-day flows were in the 27th percentile). This short position was almost fully unwound when investors began to sell dollars again.
It seems as though the Chinese are not alone in being uncomfortable holding a long dollar position. At some point a weakening dollar will attract bargain hunters. However, the DXY index is still 6.5% higher than its April 2008 low and recent investor behaviour suggests that the currency faces headwinds. Investors were willing to go long dollars during the worst of the financial crisis. They seem reluctant to do so in more normal times.
A dollar rout is unlikely from here. Against both the euro and yen the currency is undervalued. However, even though no policymaker would ever utter such an evil thought, a weak dollar goes some of the way to addressing the imbalances that the G20 apparently care so much about. A gradual, orderly, decline in the value of the dollar by around 20% on a trade-weighted basis would be an unambiguously good thing.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own