Rescue plans halt dollar rally

US government plans for a fund to buy toxic assets from banks to ease the credit crisis has immediately been interpreted as negative for the dollar.

The need to raise up to $700bn to buy mortgage backed securities dramatically changes the fiscal picture for the US and raises concerns about the government’s finances.

There are even fears that it might trigger a downgrade of US government debt that could spark a run on the US currency.

“Banking crises are almost always bad for currencies,” says Steve Barrow at Standard Bank. “It’s not just the initial shock that the market does not like, it is also the messy bail-out that follows.”

Whether the US bail-out harms the dollar in the longer term is far from certain. The cost of the rescue plan and the dire position of US finances may well be overstated.

What is certain is that the rescue is threatening to halt the dollar’s recent rally. Since news of the plan first emerged on Thursday evening, the US currency has lost nearly 3.5 per cent against the euro, taking its fall in the past 12 days to 6.1 per cent.

This partially reverses the 13.5 per cent gain that the dollar made between July 15, when it hit a record low against the euro, and the one-year high of $1.3879 on September 11.

A number of factors explain the dollar’s rally from mid-July.

First, the Federal Reserve signalled that it was not going to cut interest rates any more. Second, the European Central Bank indicated that it was not going to raise interest rates further.

Third, US investors started repatriating overseas assets, particularly from emerging markets, as it became clear that the rest of the world could not decouple from the US slowdown.

Finally, emerging market central banks faced with weakening domestic currencies had to intervene in the currency markets, running down their FX reserves. This meant they had less need to sell the dollar to maintain the balance of their different currency holdings.

In these circumstances, the US government takeover of Fannie Mae and Freddie Mac, the US mortgage guarantors, earlier this month was seen as supportive for the US currency.

“We saw the government takeover of Fannie and Freddie as being good news for the dollar because the authorities were shifting away from interest rate cuts and easier monetary policy to using fiscal policy more actively to deal with the credit crisis,” says Mansoor Mohi-uddin at UBS.

However, US government plans to create a taxpayer-funded agency to buy hundreds of billions of mortgage-backed securities changed the US fiscal picture drastically.

“Already on Friday we saw euphoric investors rush back into emerging markets. This reverses the summer trend of massive dollar repatriation,” says Mr Mohi-uddin. “Moreover, if developing country central banks don’t have to intervene now to support their currencies, they won’t have to sell euros and sterling to rebalance their reserves.”

The concerns about the US fiscal position could be even more dollar negative.

Mr Mohi-uddin says that if the Fed wants a credible bail-out plan, the cost would range from $500bn to $1,000bn, adding another 4-8 per cent to the US fiscal deficit.

He says in order to stop the Fed’s balance sheet ballooning, the Treasury will have to issue new bonds to finance the deficit rather than print money as the latter would be a sure way to boost inflation.

“This puts the emphasis on US officials persuading foreign central bank reserve managers to continue buying US Treasuries in order to prevent a sudden fall in the dollar,” he says.

However, some analysts believe concerns over the US fiscal position, and a resultant downgrade in US debt, are overdone.

Hans Redeker at BNP Paribas says current dollar weakness merely corrects the dollar rebound seen since mid-July.

He notes that the US GDP-to-debt ratio was about 38 per cent before the recent crisis started, compared with an average of 70 per cent in the eurozone. “Even a $1,300bn government deficit will not push US debt levels near European levels,” says Mr Redeker. “Talk of the US losing its AAA debt rating is without substance.”

Moreover, analysts believe fears over the impact of the bail-out on the US fiscal position may be exaggerated, especially when compared with the performance of the Resolution Trust Corporation, the vehicle used to clean up the mess after the Savings and Loan crisis of the 1980s.

Capitalising the rescue vehicle will, of course, require a substantial fiscal outlay that increases gross US debt. However, equating this with higher net indebtedness, assumes the vehicle disposes of mortgage assets at a loss over time.

“This runs counter to the RTC experience: it turned a profit,” says John Normand at JPMorgan. “Thus forecasting dollar weakness on the back of fiscal deterioration seems premature.”

He expects the dollar to continue its rise against the euro next year as an acceleration in US growth eventually leads to a rise in US interest rates, while Europe contracts and eases monetary policy.

“The medium-term story is still one of the US being first in and first out of the credit muck and we doubt that investors are fully positioned for this after only two months of euro selling this summer,” he adds.

As for the short term, policymakers will certainly be hoping the dollar does not weaken too much. After all, oil and commodity prices rebounded on Monday on the back of the dollar sell-off.

A further rebound would only lead to a revival of the inflation fears that have gradually abated over the past few weeks.