Why We See A Weaker U.S. Dollar Going Forward

Includes: CNY, FXE, UDN, UUP
by: Douglas Borthwick

We wrote this original paper on August 8,2010. Some time has passed since then, and the USD/Index has dropped from 80.00 to 76.70. Meanwhile the EUR/USD has risen from 1.3250 to 1.3834. While the market has argued that this is against all odds, we argue it is to be expected and will continue going forward. Paragraphs in italics were written back in August 2010. Updates to this analysis are in regular font. We continue to expect the USD to weaken going forward, and remain short the USD/Index in our Long-Term Portfolio.

We have received a good amount of attention since we first discussed our reasoning for why the dollar would see a bout of weakness that would translate into a trend of pain. A number of things have changed since our first report in mid-June. With this report we hope to discuss in greater detail the analysis that has brought us to our conclusion. We discuss China's need and wish to diversify out of the dollar (USD) for practical reasons; we discuss the causality of China's flexibility in the CNY relative to the value of both the USD Index and SDRs; we discuss South Korea and other Asian nations interest in diversifying out of the USD and into EUR, GBP and SDRs; we discuss the growing interest rate differential between Europe and the U.S.; we discuss current market mentality and finally we discuss the U.S. Federal Reserve’s move towards quantitative easing part 2.

China and Reserves

On June 19th 2010, Yu Yongding, a former advisor to the People's Bank of China (PBOC) suggested in the China Securities Journal that China should reduce its holdings of the USD to diversify risks of "sharp depreciation." This followed on from statements made in May 2010 when he stated China should allocate its reserves in line with the weightings of Special Drawing Rights (SDRs). On July 21 2010, The PBOC’s Deputy Governor Hu Xiaolian said the PBOC would start publishing a measure of the CNY's value regularly to help them manage the exchange rate against a basket of currencies and not just the USD. Hu added the basket's compositions should be primarily based on trade weightings.

On October 31, 2011, Yu Yongding wrote in the Financial Times that “China’s faith in the U.S. dollar has been proved misplaced and it cannot afford to make the same mistake again.” Regarding Europe Yu added, “A strong Europe is always welcomed by Beijing for geopolitical reasons. As China’s most important trading partner, a financially sound and prosperous Europe is firmly in China’s interests. Sitting as it is on $3.2 trillion in foreign exchange reserves, China can help, but while it is willing to do so this will not be without conditions.”

Composition of China's Reserves, China's Trade, The USD Index and SDRs

Although the State Administration of Foreign Exchange (SAFE) is cautious in releasing reserves composition, we understand that China has approximately 2.5 trillion USD in foreign exchange reserves, of which anywhere from 65-75% are composed of USD assets. 65% of 2.5 trillion USD equals 1.65 trillion USD. To put this into perspective China’s USD foreign exchange reserves held in USD assets are greater than all of Japan’s foreign exchange reserves combined (1.02 trillion USD), more than twice the total held by the eurozone (716 Bio USD), and almost 4 times the total reserves held by Russia (456 Mio USD).

China now holds $3.2 trillion in foreign exchange reserves, up from the 2.5 trillion USD in August 2010. We estimate their reserves are 70% comprised of USD investments. This comes to around 2.24 trillion USD, up from the 1.65 trillion USD we estimated in August 2010. Their USD reserves are growing at a time that they have a diminished interest in investing in the U.S. Indeed

China's Top Ten Trading Partners






S. Korea















Source: Ministry of Commerce, The People's Republic of China. Published Jan 2009, (source)

Dollar Index Composition













Source: Bloomberg

We like looking at the USD/Index because it is well known to FX and non FX dealers. However we realize it has limitations given the lack of depth in the fixed income markets of Canada, Sweden and Switzerland.

Special Drawing Rights Composition

U.S. Dollar








Source: The IMF, As of November 23, 2006, (source)

U.S. Dollar








Source: The IMF, As of November 15, 2010 (source)

Special Drawing Rights are a better representation of an easily attained basket given their blessing by the IMF, the depth of the fixed income markets represented by the components, and the fact they are specifically mentioned by the PBOC and South Korea’s BOK as instruments of diversification.

In November 2010, the IMF increased the weight of the euro and decreased the weight of the USD within the SDR basket. This led to a re-balancing by Central Banks who follow the SDR allocation.

Reserve Diversification

As the PBOC and the State Administration of Foreign Exchange (SAFE) has hinted at wanting to reduce its exposure to U.S. Treasuries (comments from Yu Yongding), and has an interest in managing their foreign exchange reserves against a basket of currencies (comments from Hu Xiaolian), we compare the current state of China's reserves against where they should be relative to a basket defined by their trading partners, the USD Index, or Special Drawing Rights (SDRs).

Given at least 65% of current reserves are held in USD assets, China would have to reduce this overweight to come nearer to any of the weightings we look at. If they wanted their reserves to reflect their trading partners they would need to go from 65% to 13% in USDs, If against SDRs, then from 65% to 44% in USDs. Either way, anywhere from 21% to 52% of their USD reserves need to diversified to meet either basket. In USD terms that is from 525 Bio to 1.3 Trillion USD.

Special Drawing Rights (SDRs)

The IMF describes them as "an international reserve asset, created by the IMF in 1969 to supplement its member countries' official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies." Adding, "the weights of the currencies in the SDR basket were revised based on the value of the exports of goods and services and the amount of reserves denominated in the respective currencies which were held by other members of the IMF. These changes became effective on January 1, 2006. The next review will take place in late 2010." Note that last statement, the next review will take place in late 2010. If we think of the SDR like we do the S&P 500 ... Any change in the weightings will benefit or hurt each of the currencies within it, much like a stock rallies when it is included in the S&P 500. Just as with equities, when funds buy the S&P 500 each of the stocks rises (a rising tide lifts all boats), when Central Banks buy SDRs, demand rises for the EUR, GBP and the JPY. The coming review will be important.

In order to synthetically create an SDR you would go to the market and buy the respective weighting of each currency within the Index. In order to have 100 Mio USD equivalent of SDRs you would buy 34 Mio USD of EUR, 11 Mio USD of JPY, 11 Mio USD of GBP and keep the balance in USD. If someone were moving their reserves into a more manageable basket of currencies it would be obvious to market observers in that the EUR/USD, GBP/USD and JPY/USD would be bid, while the USD/Index in general sold off. This is precisely the market we have been witnessing since China allowed for greater flexibility in their exchange rate in Mid-June. The following charts really tell the story best. When China is not pegging its currency to the USD, it is buying less USD, and buying more EUR, GBP and JPY. When it pegs back to the USD, the USD is bid again relative to its peers. In the period from 2005-2008 The lock-step move in USD/CNY relative to the USD Index and SDRs is obvious. The break from 2008-2010 displays the volatility that befalls the FX market when China is not "managing" its flexible exchange rate. China's re-entry to the FX market in June 2010 managing the CNY against a basket of currencies, has seen a causal drop in the USD/Index, a rise in the value of the SDR and a drop in volatility.

Chart showing the relationship between USD/CNY and USD/SDR

Chart showing the relationship between USD/CNY and USD/SDR

We note the obvious causal relationship between USD/CNY and USD/SDR. As USD/CNY is allowed to be flexible (translated as China allows the CNY to strengthen), The value of the SDR rises relative to the USD, and the USD weakens. From the initial revaluation in 2005, USD/SDR dropped as much as, and in lock-step with the move in USD/CNY. From 2008-2010 when China re-pegged to the USD, USD/SDR took off. With the diversification program stopped, the bid for the components of the SDR dried up overnight, resulting in remarkable volatility. China's re-entry into flexibility and its diversification program in June 2010 has once again seen a drop in USD/SDR, and a remarkable bid to the SDR components (EUR, GBP and JPY).

Chart showing the relationship between USD/CNY and the USD/Index

Chart showing the relationship between USD/CNY and the USD/Index

We note the similar causal relationship between USD/CNY and the USD/Index ... As USD/CNY is allowed to be flexible (translated as China allows the CNY to strengthen), The USD/Index drops. From the initial revaluation in 2005, the USD/Index dropped as much as, and in lock-step with the move in USD/CNY. From 2008-2010 when China re-pegged to the USD, the USD/Index rose. With the diversification program on hold, the steady offer in the USD/Index disappeared overnight, resulting in remarkable volatility. China's re-entry into flexibility and its diversification program in June 2010 has once again caused a drop in the USD/Index.

The relationship has remained intact through 2011 and we expect it to remain so going forward.

Other Asian Central Banks Involvement

The value of USD/CNY is very important to China's neighbors and trading partners given they all compete for international trade. A weaker CNY gives China a trade advantage. It can export its goods cheaper relative to its peers. For this reason a tremendous amount of daily intervention occurs throughout Asia. No country wants its currency to strengthen quickly relative to its neighbors, making its goods less price-competitive. South Korea is one notable country that uses intervention through the Bank of Korea to smooth KRW appreciation on a daily basis. It does so by buying USD/KRW through agent banks in the 1M Non-Deliverable-Forward (NDF) in the New York time zone, and by buying USD/KRW on the spot market in the Asian time zone. This past week (August 2-6) was a slow one in terms of Asian Central Bank intervention, but it is telling. The below chart details the total amount of intervention we believe went though the market given our sources’ knowledge.


S. Korea







Amount (Mio USD)








India was noticeably absent from the market last week, however we see that a total of about 9 Bio USD was bought in a slow week. We understand that normally we would see anywhere from 3 to 5 times this amount going through. If Asia is buying this many USD in their time zone to keep their currencies weak, we have to ask where they are putting these USD. Are they keeping them in USD while their neighbor, China, is selling them? Or are they also diversifying their reserves?

We got a peek into Asian Central Bank decision making last week, when South Korea announced their foreign exchange reserves had risen to 286 Bio USD as of the end of July, up 11.74 Bio from the previous month, and the third largest month over month increase ever. Moon Han-geun, an economist with the BOK said, "Amid an increase in investment profits, the reserves climbed last month as a stronger euro (EUR/USD) and Pound (GBP/USD) sharply raised their dollar conversion value." He added their holdings of SDRs contributed to the move. Obviously South Korea is taking the USD it is buying in the Asian time zone and they buying EUR/USD, GBP/USD and SDRs in the European and New York time zone to diversify their reserves (See our Research Note dated August 2, 2010, Asian Central Banks Buy and Sell USD).

Remember, the 9 Bio USD estimate for last week was for a slow week, most weeks see from 27 Bio USD to 45 Bio in USD intervention from Asian Central Banks that translate into a factor of USD selling in the European and U.S. time zone to diversify their reserves.

Lately the "recycling" of overnight intervention has taken a breather, as Central Banks have been more willing to sell the USD against their own currencies. However any stabilization in Europe will see significant recycling from Asia returning. In addition we are now seeing Asian Central Banks joined by Middle Eastern Reserve managers, who are looking to sell their petro-dollars for the EUR.

How do Asian Central Banks Diversify Quietly?

The Combination of China buying less USD, and diversifying its reserves into other currencies, while other Asian Central Banks are doing similar creates a daily USD sell order that the market has to absorb. We have noted in a number of research pieces the way in which these Central Banks are adding liquidity rather than taking it. We will go through it again. If you have a good number of dollars to sell in the foreign exchange market the last thing you want to do is tell everybody. Otherwise the market will front run you and the price you get will be much worse than you would have received otherwise. When the Fed or the BOJ intervene they do so by first checking rates, then by asking prices and dealing on the price shown. This method is very good because it scares the market into reacting and so the intervention works. A line is drawn in the sand and the intervention is deemed successful.

If Asian Central Banks came to the market, checked rates and then dealt on a price, the market would work against them. Given China is long a good amount of USD it does not want the USD to weaken quickly, rather is wants a stable market, and has verbalized this a number of times. So it does not ask prices or take liquidity. Rather China and its neighbors keep USD offers in the market, so that when there is USD demand the demand runs into their USD offers. We see this daily; When the EUR/USD sells off on economic news or large flows, it runs into Asian Central Bank bids or "multi-national institution" bids. These bids seep up liquidity, reducing volatility and keeping a reign on USD strength.

The Asian Central Bank does not chase price action throughout the day; rather it sits and waits for the price to come to it. In this way they can sell a good amount of USD without alerting the market to this fact. However a simple analysis of market volatility and a currency’s path shows what is really happening. Certainly the foreign exchange market is very large, but a constant USD sell program at work on a daily basis will surely affect market movements. The chart below shows the regressed mean of the EUR/USD’s steady move higher since China allowed further flexibility in June 2010. It shows a deliberate rise, one that compliments the USD/Index vs. USD/CNY and USD/SDR vs. USD/CNY charts from earlier. The steady selling of USD by Asian Central Banks weakens the USD over time in a gradual and steady way.

In 2011, while the path has not been quite as steady as the chart above from 2010 shows, the direction has remained constant. Indeed in 2010 we stated that we expected the USD/Index would move lower by approximately 7.8% a year. As the chart below shows, the regressed mean since China’s move to flexibility continues to see a slope of 7.86% USD/Index depreciation.

Interest Rate Differentials

Now that we have discussed the steady USD selling from Asia, let's look at the other basis for currency valuation, notably interest rate differentials. In general the market likes to buy currencies with higher yields and sell those with lower yields. Lower yielding currencies like the JPY and the CHF are traditionally seen as "funding" currencies, currencies that are sold to finance the purchase of higher yielding currencies and assets. The USD is now a funding currency. The chart below shows the relationship between the 2 year swap spread differential between the U.S. and Europe. We find that when yields are higher in Europe than they are in the U.S., the EUR/USD is stronger and vice versa. With current 2yr swap rates in Europe at 1.4% and in the U.S. at 0.7%, the yield differential is definitively in the EUR/USD’s favor. Over the past five years, when the swap spread has been at this level, the EUR/USD was priced at 1.4577 in Dec 2007, 1.3150 in January 2009 and at 1.4850 in November 2009, giving an average of 1.4192. As we have said before, the yield differential on its own is crying for a higher EUR/USD.

Above is an updated chart on the relationship between the U.S./European 2-yr < interest rate differential and the EUR/USD exchange rate. The relationship held together up until the end of June 2011, the point at which "operation twist" was introduced into the market. At the time, Federal Reserve Chairman Ben Bernanke estimated that operation twist was about equivalent to a 50bps cut in the Fed Funds interest rate. Of course, that would not be visible in the interest rate differential given U.S. interest rates in this calculation do not go negative. With real U.S. interest rates being negative we have to assume the correlation between the EUR/USD and the interest rate differential has been compromised. The only way for the differential to rally is for interest rates to rise in Europe; given U.S. rates can no longer fall.

Market Mentality

With the EUR/USD trading around 1.3280 as of this writing, we note among all major investment and commercial banks that make forecasts, only Commerzbank is looking for the EUR/USD above 1.30 by the end of Q3 2010. Bloomberg has a forecast function that looks at all bank's predictions on currency levels going forward. The current Mean Estimate for Q3 2010 is 1.2400; the median is 1.2500 while the forward is at 1.3280. There is a significant disconnect here. Prior to China's flexibility announcement in June, the median and the mean were pretty much in line with the forward. Yet today they are well away from it, despite the change in yield differential and market movement. The market continues to favor short EUR/USD positions, and are pitched these daily, yet the EUR/USD continues to rally. We would argue the short-coming of a currency forecast model is that it looks at economic data and thus does not include market intervention in the calculation. Asian Central Bank intervention is throwing traditional forecasting methods out the window. You cannot forecast something that is out of your measurable control.

The EUR/USD is trading at 1.3800 as of this writing. Once again the current Bloomberg Mean Estimate for Q4 2011 is below the market forward, showing 1.3600 while the forward is at 1.3800. The market continues to favor short EUR/USD positions and once again, the EUR/USD refuses to fall. Our premise today remains the same. Asian and Middle Eastern intervention continues to throw traditional forecasting methods out the window.

Quantitative Easing Part 2

James Bullard of the Federal Reserve Bank of St. Louis and a member of the Fed's Open Market Committee last week called for the Fed up its purchases of U.S. government bonds. This had no effect on the Fed's balance sheet, but it does a number of other things. Effectively it prints money and lowers interest rates. This would be a worry if we were in an environment of growth or inflation, but with deflationary fears now the norm, the printing of money and its resultant affects are less worrisome. Moody's told Barron's "The deflation should be comparatively benign, but it's still worrisome given the fact that unemployment currently stands at 9.5% and we see a one-in-three chance that the deflation will be accompanied by a recessionary double dip." More USD in the market and lower interest rates do not bode well for the value of the USD relative to its peers.

QE2 has come and gone, and now some Federal Reserve officials are suggesting further quantitative easing will help boost asset prices. Most notable among the doves are Federal Reserve Vice Chairman Janet Yellen, stating on October 21, 2011, that a “third round of large-scale securities purchases might become warranted if necessary to boost a U.S. economy challenged by unemployment and financial turmoil.” She was joined on October 24, 2011, by New York Federal Reserve President William Dudley as he stated “I don’t think the Fed has run out of bullets”, adding, “Its possible that we could do another round of quantitative easing, we could do quantitative easing round three.”


With China and other Asian Central Banks consistently and methodically selling the USD, with yield differentials decidedly against the USD's favor, with the market mind-set still long the USD, and with quantitative easing now back on the table - perhaps coming as early as September - we have little faith in seeing USD strength until these combined factors change considerably. Our analysis shows the USD is falling and it will take a lot for it to get back up.

Our conclusion today is driven by similar factors. Central Banks continue to be the drivers, with China’s stated goal of CNY flexibility leading the charge. Back in August 2010 we expected QE2, and it was delivered. Once again QE is waiting in the wings though we do not expect it until 2012. QE3 will act as a back-stop to Europe. If they are unable to realize a higher EUR/USD through stabilizing their fiscal outlook, then we believe the Federal Reserve will be forced to step in. A strong U.S. dollar is no longer in U.S. interests. This is noted by the stock market and the U.S. administration. President Obama stated toward the end of 2010 that he wanted to double U.S. exports over five years. He cannot do that without a weaker USD. Lately the U.S. stock market has shown remarkable sensitivity to U.S. dollar strength. After all, U.S. multinationals are significantly affected by a stronger USD as demand for their exports dry up. We remain convinced of USD weakness going forward. Against the USD/Index, Asian currencies and Latin American currencies. Once again, the USD is falling and it will take a lot for it to get back up.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.