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23 Sept 2011

Currency Knowledge Series 5- Reasons for USD Strength

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The link between currencies, commodities and equities has never been as apparent as in the August-September 2011 period.

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Arjun Parthasarathy

The link between currencies, commodities and equities has never been as apparent as in the August-September 2011 period. A broad risk reversal trend boosted the US Dollar  (USD) while taking down emerging currencies, global equities and commodities. The following charts showing the drop in the Indian Rupee (INR) against the USD and the accompanying fall in the Indian benchmark equity index and the benchmark commodity index the Reuters Jefferies CRB index highlights the link.

The movements have been sharp with all the above indicators falling by 10% to 11% each in the period 1stAugust 2011 to 22nd September 2011. The reason for the INR, Sensex and CRB index fall was the flight to safety by investors on worries of global growth and Eurozone debt issues. The USD was the beneficiary of the flight to safety with the USD index rising by over 5% in the same period.

Why is the USD strength reflected in weakness in risk assets?

The reason for sharp trend reversals due to USD strength is that the world borrows money in USD and invests in assets across the world. The activity is termed as “carry trades” as funding in USD is lower than the returns received from investing in risk assets. Risk assets for the purpose of “carry trades” include currencies and bonds. Equities and commodities gain due to carry trades on the back of increased liquidity on a global basis as markets borrow and invest. Leveraged money flows into any asset class that can potentially deliver higher returns.

How do carry trades work?

The carry trades depend on the policies of central banks. Let us take the example of the US Federal Reserve (Fed) and the Reserve Bank of India (RBI). In the period 2010 to 2011, the Fed maintained policy rates at 0% to 0.25% while the RBI raised policy rates from 4.75% to 8.25%. Borrowing in USD was cheap with borrowing costs at less than 0.5% (the benchmark borrowing rate is the Libor or London interbank borrowing rate). Investing in INR deposits at around 8% earned an investor borrowing in USD a spread of 7.5%. In this picture will come in hedge costs of interest rate risk, foreign exchange risk and credit risk, which will lower the spread, but the fact is that it did pay to borrow in USD and invest in INR assets.

This carry trade was not only happening between USD and INR it was happening with USD and all other currencies as well including Korean Won, Brazilian Real etc. The whole world was short USD and long everything else.

Why sudden trend reversals?

Trend reversals happen when fundamentals change or when there is fear among investors who have borrowed in USD and invested in risk assets. In the most recent case of trend reversal, the flight back into USD was due to a) worries of debt default by Greece b) inflation in countries like India, China and Brazil forcing central banks to raise rates and bring down growth and c) the policy of the Fed to not to print more USD to pump prime the US economy.  The markets took sudden fear to the collapse of a world financial order and ran to the safety of US treasuries. In the whole trend reversal period US benchmark ten year treasuries saw yields falling by 80bps as more and more investors bought into the safety of treasuries.

Greece is close to defaulting on its sovereign debt, as it does not have the money to pay bondholders. There is no one to buy new Greece debt and its revenues are not enough to pay off maturing debt. Two year Greece bond yields went up to 60% on debt default issues. Inflation in India, China and Brazil trended at three year highs due the large scale stimulus provided by these countries in the form of loose fiscal and monetary policies post the 2008 financial crisis. The high trending inflation forced these countries to adopt a tight fiscal and monetary policy approach to bring down inflation expectations. Growth in these countries suffered as a result of tight policies leading to fall in equity valuations. The Fed had carried out a bond purchase program for USD 600 billion in 2010-11 to spur a sluggish US economy. The bond purchases termed as quantative easing supported the economy as the Fed printed money to buy bonds. The printing of the money by the Fed led to carry trades weakening the USD.

The Fed is not undertaking a similar bond purchase program in 2011-12 leading to fears of lower USD liquidity available for carry trades. This fear of lack of liquidity resulted in winding up of carry trades where investors sold risk assets to convert the money back into USD. The result of the reversal is there in the charts shown above.

The link between currencies, equities and commodities while clearly established in the short term does not really hold true in the very long term where pure country fundamentals come into play. However, short term is very painful if one is at the receiving end of the carry trade.

 

Disclaimer:

Information herein is believed to be reliable but Arjun Parthasarathy Editor: INRBONDS.com does not warrant its completeness or accuracy. Opinions and estimates are subject to change without notice. This information is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The financial markets are inherently risky and it is assumed that those who trade these markets are fully aware of the risk of real loss involved. Unauthorized copying, distribution or sale of this publication is strictly prohibited. The author(s) of the content published in the site INRBONDS.com may or may not have investments in the assets discussed in the pages/posts.

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