Friday, February 18, 2011

Playing the intermediate dollar moves

The dollar is a strange animal because it has a special place as a safety asset. If risk-taking is off, there will be a flight to the dollar. If risk-taking is on, the dollar will decline. This safety behavior is associated with reserve status even if the current account and fiscal deficits are high.

Another way of viewing the dollar is through capital flows and not just risk-taking safety behavior. The capital flows argument suggests that the dollar is counter-cyclical. It will under-perform when there is global economic expansion. This under-performance of old world currencies is a result of it being a supplier of equity capital to the rest of the world in an expansion. In a contraction or when risk increases, there will be a pull-back of flows and a dollar appreciation. This capital flows argument applies especially to emerging markets. Hence , if there is further strong global growth, we expect to see USD to depreciate versus EM currencies. This should be more pronounced for commodity currencies. This relationship will not apply to G-10 currencies where rates and relative growth will be the main drivers.

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