The US dollar has come under major pressure, with the US dollar index (a composite of the dollar against various currencies) falling to 4-month lows. The weakness of the US dollar has been broad based and even the Japanese yen which normally weakens as risk appetite improves, has strengthened against the USD. The euro has also taken advantage of dollar weakness despite ongoing concerns about the European economy. The main source of pressure on the dollar is the improvement in market appetite for risk.
As I noted in a previous post, “What drives currencies?” risk appetite has been one of the biggest drivers of currencies in the past year. This has pushed other drivers such as interest rate differentials into the background. In the post I also stated that we would all have to watch equity markets to determine where currencies will move, with stronger equities implying a weaker dollar.
The dollar looks particularly sickly at present and it is difficult to go against the trend. It will need a major reversal in equity markets or risk appetite to see a renewed strengthening in the dollar. Although I still think it will require some positive news as opposed to less negative news to keep the momentum in equity markets going (see previous post) the prospects for a stronger dollar remain limited.
Over the coming months the dollar is set to weaken further and those currencies that have suffered most at the hands of a strong dollar will benefit the most as risk appetite improves. It is no coincidence that the UK pound has strengthened sharply over recent days, and this is likely to continue given its past undervaluation. Other currencies which were badly beaten such as the Australian dollar and Canadian dollar will also continue to make up ground, helped too by a rebound in commodity prices.
Aside from improving risk appetite the dollar may also come under growing pressure from the Fed’s quantitative easing policy, especially if inflation expectations in the US rise relative to other countries as a consequence of this policy. It will be crucial that the Fed removes QE in a timely manner and many dollar investors will be watching the Fed’s exit strategy closely.
Although the US trade deficit is showing improvement another concern for dollar investors is the burgeoning fiscal deficit. The US administration revised up its estimate for the FY 2009 deficit to $1.84 trillion or about 12.9% of GDP, highlighting the dramatic deterioration in the US fiscal position. Concerns about this were highlighted in an FT article warning about the risk to US credit ratings.
The deterioration in dollar sentiment has also been reflected in speculative market positioning, which has seen speculative appetite for the dollar drop to its lowest level in several months. The bottom line is that any recovery in the dollar over the coming weeks is likely to be limited offering investors to take fresh short positions as investors continue to move away from holding the dollar.