Return of the Dollar?

by: Jim Delaney

Each day the basis for this piece is the cross asset relationship between credit spreads and equity prices. At times that is accomplished from a slightly higher altitude with a look at macro factors affecting entire economies vs. the CDS/equity relationship of a specific company.

Given an interesting occurrence on Friday, I thought we’d take one day and go up a few thousand more feet, as a broader perspective is needed. Hopefully you will agree it was worth wearing the oxygen mask.

Between the time when people stopped trading goats for shells and started securitizing toxic assets, each country created its own currency, pre-Euro of course, and doing business across borders meant changing your money for your counterpart's and vice versa to execute the transaction. We take much of this for granted now but in the early days of commerce, it was what the financial markets were all about.

So, just days after hitting its lows for the year due to the demand for riskier assets and a move away from safe haven plays, the U.S. Dollar promptly did an about face on Friday and moved higher against the Euro and Japanese Yen after the economic numbers were released. The reasoning? “The report may be so strong that it prompts players to rethink assumptions about the pace of the recovery, the timing of the Federal Reserves normalization of interest rates and ultimately the relationship between the stock market and the Dollar,” Michael Woolfolk, senior currency trader at Bank of New York Mellon said on Friday.

Nick Bennenbroek, head of currency strategy at Wells Fargo Bank in New York added to this view saying:

“The tight inverse correlation between the dollar and equities is potentially easing, and we are not seeing wholesale dollar selling. If so, relative economic performance will become increasingly important and on that basis, we still expect the Dollar can outperform the Euro and Yen in the month’s and quarter’s ahead.”

In short, if the world is convinced we’re going to come out of the hole first, they’re going to want to come along for the ride and to do that they’re going to need to have Dollars to buy $ denominated assets.

The reasoning behind the demand for Dollars switches from a good place to hide from the storm to the place you want to be after the storm has passed. Funny too then, after all of the harrumphing going on around the world about the USD losing reserve currency status, that many of those same participants have little problem spinning 180 degrees in their reasoning to hold USD assets.

In light of Friday’s reversal, one must also consider the relationship on those commodities that are considered hedges against USD weakness, mainly oil and gold.

The reasons for owning the latter of these two have too many factors to analyze in such a short space but oil has very much been the market where investors express their views on the USD.

Last spring, as oil climbed to almost one hundred and fifty dollars a barrel, the Dollar remained range-bound, tossed between those who wanted to own the currency for its safety and those who preferred a more “liquid” asset. In the fall, when it looked as if the USA was flagship of the global flotilla heading towards the edge of the world, both the Dollar and oil declined in value.

When Uncle Sam left Lehman Brothers for dead, the Dollar rose like a phoenix from the ashes and in reasonably correlated fashion “erl” and the Buck have sailed to sunnier climes.

A recovery in the global economy will increase the demand for fossil fuels supporting the price of oil but as the two FX specialists said above, should the U.S. be seen as the flagship of the fleet, the Dollar will remain prominent.

The 5 year CDS level for the U.S.A. closed at 27bps on Friday, up from a low of 25bps on August 4th. The increasing debt issuance to fund various transfer payments disguised as stimulus spending could account for the recent up-tick.

Japan’s 5 year CDS closed at 39bps on Friday after touching 37bps on 8/5. The Euro is a common currency but each country in the ECB has their own CDS level. Since Germany is the largest economy in that group we’ll use their CDS levels as a proxy for the region. Germany’s 5 year CDS level was 25bps on Friday after a recent low of 23bps which was the previous low for the year, reached back on May 11th.

Enjoy the week.