January 4, 2013 5:24 pm

Bet on US growth set to boost dollar

US Dollar©AFP

After a week of tense political negotiations, the US has managed to avoid going over the fiscal cliff. But where does this leave the US dollar? In fact, investors and analysts are tipping dollar strength this year – and not because it will benefit from haven demand in a faltering global economy.

Instead, they argue that, if the US economy continues to show signs of recovery, the dollar could rise in line with US equities. And, after a year that saw some of the most unusual investments turn out to be the most lucrative – such as buying Greek bonds – contrarian bets such as this are in fashion.

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Predicting the end of monetary easing in the US has been tipped as one of the key drivers for the dollar this year. The release of minutes from the Federal Reserve's December meeting this week has already thrown this factor into play. The dollar shot up against other major currencies after it emerged that the Fed was considering ending its third round of bond buying to stimulate the economy at some point this year.

Analysts believe that could pave the way for the dollar to rise this year in line with improving signals on the US economy – which would be an unusual pattern for the currency in recent years. 

“At some point in 2013, US interest rate markets will react to an improving economic outlook, and the ‘good data, weak dollar' causality which we have been watching in recent years will fall apart,” predict analysts at Société Générale.

Ever since the tech bubble burst at the start of the century, the dollar has been in a long-term decline. From the summer of 2001 until just before the financial crisis of 2008, the dollar index, which weighs the dollar against a basket of other major currencies, lost 40 per cent of its value, thanks in part to aggressive monetary easing from the Federal Reserve. In addition, central banks, which are huge holders of US Treasuries, have tried to reduce their reliance on the greenback, adding to the weakening effect.

But since the collapse of Lehman Brothers, the dollar has been one of the assets most sensitive to the so-called “risk on, risk off” phenomenon. In part this is because US Treasuries are used as a global haven. But it is also because the dollar is so ubiquitous that investors tend to use it to fund themselves, borrowing in dollars to invest in riskier assets. So when global risk appetite rises, the dollar tends to fall. 

Yet the dollar's attractiveness as a funding currency may be waning. Analysts already believed before the release of Fed minutes this week that the US was closer to the end of its monetary easing cycle than other large, liquid currency markets. 

“The debate on QE eternity has dissolved into debate on whether QE ends mid-2013 or end-2013,” says Alan Ruskin, a currency strategist at Deutsche Bank. “The latest events confirm that the US dollar is not a favoured funder for 2013.”

Both Europe and Japan are still widely expected to ease further this year. Using the euro in so-called carry trades, borrowing in a low yielding currency to invest in higher yielding ones, became popular in 2012 after the European Central Bank cut interest rates. That trend looks likely to continue.

Meanwhile, the yen is also expected to weaken further. The new government elected in December has vowed to get tougher on combating deflation and the strong yen, leading many currency analysts to tip a weaker yen this year.

“I don’t see why you’d use the US dollar as a funding currency when you could use the yen,” says Simon Derrick, a currency strategist at BNY Mellon. “That will start to change the way the dollar trades.”

The argument that the dollar could rise in line with US equities this year tends to assume the US economy will improve in 2013 and that this will entice international investors, who are not using the dollar as a funding currency, into the S&P 500. But the dollar could also correlate with US equities if both are falling. Daragh Maher, a strategist at HSBC, says if the US remains at threat of a downgrade, the dollar will seem a far less attractive haven.

Of course, a level of scepticism over the stronger dollar theory remains. Betting the dollar will correlate with equities has been like betting the yen will weaken: two classic theories in the currency markets that have defied expectations in recent years.

“Market hopes that the greenback would perform well in 2012 on the back of US growth have been severely disappointed as the US dollar has instead been undermined by the actions of the Fed and other central banks,” says Jane Foley, a currency strategist at Rabobank.

Still, with the yen losing about 9.5 per cent of its value in the past two months alone, one of these contrarian forex bets seems to be coming to pass. Analysts believe 2013 could be the right time for the other one, as well.

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