To spice up their working day, foreign exchange traders often like to assign personality traits to currencies.
The US dollar has most frequently been characterised as the hard man of foreign exchange. Like Arnold Schwarzenegger in the Terminator films, it has seemed capable of taking any kind of punishment.
In recent months the dollar has once again been living up to this reputation. With the US trade deficit hitting a record $66.1bn (€56bn, £45bn) in September, the dollar should be vulnerable. Instead it has been pushing back the euro and the yen, gaining close to 14 per cent against both so far this year.
Rather than contributing to a reduction of global financial imbalances, as most economists expected, the dollar is again moving in the wrong direction.
So what explains the dollar’s gravity-defying performance – and does its recent climb merely heighten the chances of a collapse in the future?
The most obvious explanation for the dollar’s rise has been the increased interest rate premium offered by the US compared with Europe.
At the end of last year, 10-year US government bonds were paying about half a percentage point more than their eurozone counterparts.
Since then, the US rate advantage has more than doubled to about 1.14 percentage points.
The dollar has also been strong against the yen at a time when economic news from Japan has been surprisingly robust. Although the rate premium offered by the US on 10-year bonds has risen only fractionally, the US advantage in short-term rates has increased more dramatically.
The Federal Reserve has lifted rates by 175 basis points this year while the Bank of Japan is expected to keep rates at zero until it sees convincing signs that the recovery is well established.
Aside from government interest rates, foreign investors have become increasingly interested in securitised mortgage debt.
“With the US housing market booming, this has offered higher rates and a sense of safety,” says Mark Zandi, head of research at Economy.com, a consultancy. “Global investor holdings of US mortgage-backed securities are now approaching $3,000bn, more than a quarter of all foreign holdings of US assets.”
Many economists are concerned that the US is investing too much of the money borrowed from abroad in housing, rather than in efforts to expand the country’s productive capacity. This may make it harder to reduce the trade deficit in years to come.
The dollar may have also benefited from the political disarray in Europe, starting with the rejection of the European Union constitution, the lack of a decisive mandate in the German elections and, most recently, the riots in France.
“For those looking to the euro as a baby reserve currency to rival the dollar, this has been a disappointing year,” says David Bloom, currency strategist at HSBC.
The US Congress may have done almost as much for the dollar as the Federal Reserve this year, according to some economists. The Homeland Investment Act provided a temporary incentive for companies to bring foreign profits back to the US, reducing the usual 35 per cent tax on overseas earnings to 5.25 per cent.
Tony Norfield, head currency strategist at ABN Amro, estimates that companies brought back about $40bn in the first half of the year and are on course to bring back about $100bn in the second half.
For most companies, this tax break will expire at the end of the year, and soon after that for others.
Most economists are hoping the dollar rally will not last much longer. “A rising dollar takes us further away from the goal of rebalancing the global economy,” says Peter Hooper, chief US economist at Deutsche Bank. “The larger the imbalances become, the greater the chances of a disruptive fall in the dollar.”
The dollar is still down about 13 per cent from its trade-weighted peak in early 2002, and there is good reason to expect this trend to resume next year.
The interest rate premium offered by the US is not expected to get much wider, and the repatriation of US corporate profits should slow dramatically after December.
In addition, if the Japanese economy continues to pick up, as is expected, a growing proportion of that country’s savings will be used domestically rather than diverted to the US.
If the dollar does resume its fall, economists believe its recent rises will not have done much damage. US exporters have continued to benefit from the modest fall in the currency since 2002.
But having been surprised so often by the resilience of the US currency, few economists seem willing to bet too heavily against the dollar.