*Reference to the ‘Dollar Smile’ theory (explained by Macro Man, coined by Morgan Stanley):
One possible explanation is an emerging school of thought that a US recession/quasi-recession is actually good for the dollar. According to the proponents of this theory, weak/negative US growth is both damaging to the rest of the world and a catalyst to encourage US investors to bring money back home. The upshot is that there is less demand for foreign assets/currencies and more demand for US assets/currency; hence, the dollar rallies.
By gauging the sentiment of news flow in the past week, the answer to the question of continued strength in the Dollar would seem to be no. First, a little history:
The dollar picked up steam back in December once the thesis that the world economy could “decouple” from the woes of the US fell apart — it became clear that the BRIC economies are less equipped to deal with fallout from the credit crisis, and are more likely to default on their own debts. As stated above, this led investors to unwind their investments in emerging markets, and bring them back into US cash (a more liquid asset). Since stocks were tanking, coupled with the Federal Reserve’s intent to suppress interest rates with its various liquidity programs (TARP, TALF), many investors sought safety and bought US bonds — to at least yield some sort of return while on the sidelines. Since March 9th (the recent bottom in equities), there has been a departure from risk aversion, and more investors have sought the same risk they did last summer in commodities and emerging markets.
here’s a chart of the MSCI Brazil index (a basket of stocks which is representative of Brazil’s economy):
Here’s how the 10-year note has performed in the same time:
Yields have gone up (which means people are selling) while emerging markets are simultaneously attracting new capital. The dollar has also weakened – although slightly – which raises the question of a weaker dollar going forward with rising inflation expectations. Tony Crescenzi has stated that the dollar may slowly relinquish the status of being the world’s leading currency, as the dollar is now 63% of the world’s reserve assets (compared to 70% back in 2002). However when considering alternatives (particularly China) he says:
China’s renminbi is ascending but not suitable for parking the world’s reserve assets because there is no bond market there. Moreover, the renminbi is not yet widely used for commerce and in contracts.
Well, Tony may have spoken too soon.
From the Financial Times:
Brazil and China will work towards using their own currencies in trade transactions rather than the US dollar, according to Brazil’s central bank and aides to Luiz Inácio Lula da Silva, Brazil’s president.
An official at Brazil’s central bank stressed that talks were at an early stage. He also said that what was under discussion was not a currency swap of the kind China recently agreed with Argentina and which the US had agreed with several countries, including Brazil.
“Currency swaps are not necessarily trade related,” the official said. “The funds can be drawn down for any use. What we are talking about now is Brazil paying for Chinese goods with reals and China paying for Brazilian goods with renminbi.” (Emphasis Added)
The scale of the agreement wouldn’t be enough to dramatically affect the FX markets, but it could if this idea appeals to other foreign countries. Brazil has discussed selling 10 and 30 year bonds in International markets this year, which would add to the currency’s liquidity…which satisfies another trait of a desirable currency.
As many of the world’s economies embrace foreign investment (Malaysia’s FX market is currently closed to outsiders, for example), and as our domestic economy releverages money from this period of zero interest, the dollar may wear a frown sooner than expected.
