The Dollar Is a Safe Haven? You Bet

In the previous post we mentioned that the U.S. dollar (strangely enough) is actually a safe-haven currency. Some Sober Look readers were quite astonished by this statement. How can the dollar be one of the currencies investors flock to during periods of increasing risk aversion? Doesn't seem likely after what the U.S. has been through and with all the new dollars entering the system from the Fed's quantitative easing? But here are some reasons this may not be so crazy after all:

1. As we discussed earlier, the low U.S. borrowing rates make the dollar a perfect carry trade currency to short. That means any increase in volatility will push investors into unwinding the carry trade by buying back the dollars they've been short. When risk aversion recedes, investors put the carry trade back on by shorting the dollar.

2. Switzerland is no longer considered a safe haven due to its exposure to the banking sector (significantly larger as a fraction of the GDP than that of the U.S.) and increased transparency with regard to depositor accounts (reducing the amount of deposits at Swiss banks.) Therefore the Swiss Franc is no longer as attractive of a place to park investors' cash.

3. The U.S. has a deep short-term government bond market, making it easy to park dollars and maintain tremendous liquidity if need be.

4. Currencies that have exposure to commodities are considered a leveraged bet on the global economic recovery. These include the Australian and the Canadian dollars and are expected to benefit from strong commodity prices. The same applies to many emerging market nations, who will benefit from any recovery much faster than the developed nations. Any threat to the speed of the recovery sends investors running back to the U.S. dollar and Yen.

5. The Yen, the other safe-haven currency, is a bit more of a problem (relatively) these days because Japan's deep recession and government debt levels far beyond other OECD countries makes investors uneasy. It's still one of the top choices, but has given ground to the dollar as the boring place to park cash.

6. Gold is another such currency, but it lacks the liquidity of the dollar, which is so critical in this environment.

The data actually supports the "dollar safe-haven" hypothesis. As a safe-haven currency, one would expect the dollar to rise at times of high risk aversion and fall in periods of increasing confidence in the global recovery story. We compare the dollar over the past year with the VIX index and the JPMorgan composite investment grade corporate bond spread. Both should act as indicators of risk aversion.

Here is the chart of the dollar value against a basket of six major currencies (labeled "DXY" in the charts), versus the VIX index.

Click to enlarge:


source: Bloomberg

Below is the historical correlation chart of the dollar value (against a basket of six major currencies) versus the VIX index (note: the positive correlation actually started in the fall of 08, but is on a lag due to the moving window over which correlation is measured.)

Click to enlarge:

source: Bloomberg

This is a chart of the dollar value versus the JPMorgan corporate investment grade spread index (labeled JACI):

Click to enlarge:

source: Bloomberg

Below is the historical correlation chart of the dollar value versus the investment grade spread. Positive correlation shows flight to dollar during periods of widening spreads and the correlation has been positive and stable recently.

Click to enlarge:

source: Bloomberg

There is no question that recently (since the fall of 08) the dollar has become the equivalent of a money market fund in the universe of currency investment choices. It's a temporary place to park your money to wait for each mini-storm to blow over, before putting the money back to work.

Comments

[artkarl:]

Dollar strong, who'd a thunk it?

Sep 15 08:07 AM

[Vuke:]

Thank God it's been strong for a hundred years - and has only declined 96% in value.

Imagine the drop if it actually turned weak.

On Sep 15 08:07 AM artkarl wrote:

> Dollar strong, who'd a thunk it?

Sep 15 08:59 AM

[Uncle Pie:]

The dollar is only a "safe haven" if you are keeping score in dollars. In terms of purchasing power, the US dollar has lost 94% of its value since Franklin Roosevelt made it illegal for US citizens to own gold in 1933. When I visited Switzerland in the mid 1970s, a US dollar bought 4 Swiss francs with a few pennies left over. Today it will buy just ONE Swiss franc with a few pennies left over. And you tell me I should prefer the US dollar to the Swiss franc? Hello?

Sep 15 09:02 AM

[EUARTE:]

Anybody in Brasil would laugh at this.

Sep 15 10:55 AM

[Tony Daltorio:]

The author conveniently ignores the remaining problems in the US financial system - nothing has improved, it has been temporarily "papered" over.

Think about putting money into the US Dollar this way - say a nuclear bomb goes off; putting money into the US Dollar would be like running full speed TOWARD the nuclear blast. Not too smart........

Sep 15 01:48 PM

[nobby73:]

Good article, I see point 3 as the main one, the dollar liquidity is the main power of the currency, and point 1 explains why it rallies in the face of bad news, even if this comes from the US.

Dollar has been a carry trade on a highly leveraged housing market and financial system, the crisis caused a huge rally but now comes the realization that the Dollar will suffer as the system normalizes owing to its weakness on a macro level. The question now is can it find a path to a normalized level without tipping the global economy back into recession?

As an aside, just went to Brazil and they aren't much interested in the Dollar, but Euros are well received.

The "risk aversion" trade is an irrational but herd-like move and I expect this to decline going forward.

Sep 15 02:20 PM

[Donald Ingram:]

You are doing a very good job of talking yourself into having confidence in your decision to have confidence in the dollar!
Please consider;
www.moneyandmarkets.co...
The USD is NOT seen as a safe haven this time around, as it WAS seen one year ago. The trap door is starting to open! Don't get caught standing on a pile of cash! Good luck.

Sep 15 05:00 PM

[QuasiYoda:]

The first 4 comments don't understand what the author is saying. He is not commenting the quality of the dollar. He is talking about how it is still used in international finance and in that role it could easily be bought up thus driving the dollar index back up.

Right now it is a Contrarian Play everybody knows it is going down . . . . We shall see!

Sep 15 06:12 PM

[Steven Vincent:]

The dollar may experience continued weakness as global equity markets continue their surge but that correlation may find its limits as the dollar reaches the area of its prior low. From there it may actually strengthen with the global economy as demand for dollars increases with the growth in global trade and development.

Sep 15 11:55 PM