US DOLLAR MOVEMENTS IN 2009

2008 has been an exceptionally active year in the foreign exchange market as currency volatilities hit record highs. In the first half of the year, everyone was worried about how much further the dollar would fall but in the second half of the year the concern became how much further the dollar would rise. After hitting a record low against the Euro in the second quarter, in the beginning of the fourth quarter, the US dollar actually surged to a 2 year high. When we have a glance at historical movements Dollar index made high of 164.72 in 1985 after that it made low of 78.19 in 1992, which was slump of 52 %from its highs. When we see the recent movement of this new millennium we notice that it made high of 121 in 2001 while it made low of 70 in March 2008. After making that low it has shown bounce back to 88.46 in November 2008.So in 2008 it has increased nearly 18%from its lows. While it again fell to nearly 78 in mid December to due serve interest rate cut by the Federal Reserve. But recently it’s again bounced to trade near 83 levels.

Risk aversion, deleveraging and repatriation have largely driven the dollar’s rally in the second half of 2008.

NEGATIVE FACTORS THAT CAN PRESSURIZE US DOLLAR INDEX IN 2009

-Foreign central banks selling US assets

Oil Producing Nations
Crude oil prices have melted drastically which led to reduction of revenue of oil producing nation’s .So Oil producing nations will have support their spending by selling their accumulated dollar assets. Ex Russia has already sold over 20% of its $598.1 billion reserves, and it can be expected to continue doing so this year.

Emerging markets that have been relying on capital flows to fund their trade deficits
Many emerging markets around the world have been running trade deficits in recent years financed by capital flows. India’s strong capital flows from tourism, software services, and remittances not only financed its trade deficit, but also increased its foreign reserves to an all-time high of 316.2 billion in May of 2008. India’s central bank, for example, has been forced to sell off its US holdings to curb its currency’s decline, and its total reserves have decreased by $62.2 billion. The central bank’s dollar sales in October alone exceeded purchases by a record $18.7 billion.

-US Trade deficit is worsening

As imports to the US are falling, exports are falling even faster. Demand for the durable and capital goods produced by “developed” nations is plummeting much faster than demand for cheap consumer imports, causing widening trade deficits with nations like China.

-Rising gold prices

Rising demand for physical gold is a threat to the dollar because it signals a growing loss of confidence in the paper currency. All the gold that has ever been produced would fit in a solid cube of about 19 meters on each side, and this cube is only expanding by about 12 centimeters a year (2%). Since the value and supply of gold it is fairly constant over long periods of time. So by seeing the ever-increasing demand its prices can remain on firm side.

-Hazard of bailouts

While bailouts might have an adverse effect on the future actions of individuals and businesses by encouraging risk taking, the real problem is their effects on future actions of the government. Specifically, each bailout makes it harder to say no to the next bailout.

Each bail out adds increased pressure on the government expenditure plans as all ailing sectors are asking for bailouts packages and it is difficult for the particular government to address issues of all sectors.

-US budget deficits

According to the latest government figures in US, the deficit currently is expected to be $438 billion. For a reliable idea of what our 2009 deficit will look like, to this number we need to:

Add the cost of funding the on-going wars in Iraq and Afghanistan
Add the cost of current and future bailouts for the auto companies
Add the cost of another stimulus package

2009 budget deficits will force the government to sell at least another 2 trillion treasuries this year.

-US economic troubles

Manufacturing sectors problems
The full effect of last year’s big drop in manufacturing orders, including job and production cuts, will only be felt throughout the course of this year. First quarter of 2009 is not going to look pretty for US manufacturing sector. Federal bailout, states will still need to drastically reduce spending and raise taxes. When US states cut spending, they lay off employees, cancel contracts, eliminate or lower payments to businesses and nonprofit organizations that provide direct services, and cut benefit payments to individuals. These cuts, like new taxes, drain an enormous amount of money out of circulation. This leaves business and individuals with less cash and thereby removes demand from the economy, causing state and federal GDPs to contract.

China become skeptical about US treasury
Sovereign wealth funds like China have become skeptical of buying more US paper. According to an editorial in the state owned newspaper, China Daily, “China’s increased purchase of U.S. Treasury securities should not be interpreted as an endorsement of the assumption that the U.S. can borrow its way out of the current financial crisis.” If dollar demand continues to wane, it is another factor that could drive the dollar lower in the first half of 2009.

FACTORS FAVORING UPSIDE IN DOLLAR INDEX

-Rescue of US dollar by Arabian countries

Throughout the US-dollar’s 40% slide over the past six-years, the Arab oil kingdoms in the Persian Gulf stayed loyal to their US-dollar pegs. The Arab oil kingdoms rescued the US-dollar from the brink of collapse, by rapidly expanding the supply of Kuwaiti dinars, Saudi riyals, and UAE dirhams, and then recycled about $250billion of Petro-dollars into US Treasuries over the past 12-months.
The recycling of Arabian Petro-dollars into US Treasuries put a floor under the US $ Index at the 70-level last year, and persuaded bearish currency traders to cover massive short positions that had been built-up in the US $ over the past six-years.

-Flight to safety in US dollar

Despite the next to nothing yield offered by dollar denominated investments, a flight safety into US dollars and government bonds has kept the greenback from collapsing against other currencies like the British pound, Canadian and Australian dollars. The concern for safety was so high that investors were willing to take negative yields just to park their money with the US government. A bubble is brewing in the Treasury market and any improvement in risk appetite will take the market’s focus away from safety and back to return on money at which time ultra low interest rates could become a detriment for the US dollar.

-Liquidation by hedge funds

During the second half of 2008, a “flight to quality” began as hedge funds sold foreign assets to meet redemptions requests. These forced repatriations by hedge funds combined with dollar’s outdated reputation as a safe haven produced a record breaking rally in the treasury markets.

-Interest rate cut By ECB

Next to the Bank of Japan, the ECB has been the least aggressive central bank in 2008, having cut interest rates by only 150bp to 2.5 percent (counting the 25bp rate hike, their total easing is 175bp YTD). Compared to the 400bp rate cut from the Federal Reserve and the 350bp rate cut from the Bank of England, the ECB’s nimble move single handedly prevented the Euro from collapsing. BOE is having its meeting on Friday while ECB is having its meeting on 15th of this month in which they can announce the interest rate cut which are at 2% and 2.5% respectively.

-Deflation in US …Good for dollar index

Deflation means most asset prices go down. When asset prices go down, anyone who owns those assets loses money.
From peaks reached just a few months ago to the latest bottoms, the price of oil has plunged 73% … copper has fallen 66% … lead and nickel are down 73% … platinum is down 66% … and wheat is off 64%.
Even the US government’s slow-to-change, lagging index of inflation — the CPI — has caved in to deflation, falling by the most since the government first introduced the index in 1946.

Debt liquidation
That’s the main engine behind the deflation and a major element in vicious cycles that are just beginning to gain momentum. Consider the housing market, for example. The more debts are liquidated, the more prices fall … and the more prices fall, the more people abandon their homes and mortgages, leading to more debt liquidation.

Why deflation is good for Dollar index
When the price of investments or goods and services goes down, the value of each dollar goes UP. When there’s global deflation, the dollar is the prime beneficiary.
Everything that matters in the global economy — trade, commodities, GDP, debts — is measured in U.S. dollars. The dollar is the world’s reserve currency.
The dollar now buys three times more oil and copper than just a few months ago. Not just 20% more or 50% more, but three times more! So with the falling commodity prices the purchasing power of dollar increases.
Now as we have deflation and global contraction. Despite the Fed’s efforts to lower interest rates, credit — dollar credit — is drying up all over the world because only selective credit is extended due to fear factor. The overall supply of dollars is contracting because of lower dollar credit. So U.S. dollars become scarce and its value is going up.

-Contraction in other economies
A country’s currency is never valued based on how well or how poorly that particular economy is doing in isolation. It’s always measured against another country’s currency. So it is always valued based on how a particular economy is doing relative to another economy.

Meaning thereby US economy is shambles but other economies such as euro zone are also slowly faltering which can lead to further downside in euro currency. Furthermore Europe’s banks have lent more than $2.7 trillion to the high-risk emerging markets, and those emerging markets are being crushed by deflation.

In just the last five months the commodity currencies such as the Australian dollar has lost 31% of its peak value. Other currencies tied to commodities are also getting killed such as New Zealand dollar is down 39% from its peak; the Brazilian real, 35%; the Canadian dollar, 23%.

CONCLUSION

Volatility in the currency market hit a record high in 2008 but in 2009 I expect the volatility to compress as interest rates around the world converge. Much of the volatility this past year has been spurred by speculation about how much various central banks would cut interest rates.

News about Obama’s economic team working on a new Stimulus plan including tax-cuts by approximately $300 billion has fuelled stock markets and dollar index higher. The wave of optimism have sunken the Euro and Yen yesterday while boosting the Dollar.