The dollar was beaten up over the past week, finally breaking through some key levels against many major currencies; the dollar index touched 76.457, the lowest since September 25, 2008. The usual explanation for dollar weakness over recent months has been an improvement in risk appetite. However, this explanation fails to adequately explain the drop in the currency over recent days.
Although we have seen a multi month trend of improving risk appetite it is not clear that there was any further improvement last week. On the one hand the ongoing rise in equity markets points to a continued improvement in risk appetite; the S&P 500 recorded its biggest weekly gain since July. Equity volatility has also declined, reflected by the decline in the VIX index.
On the other hand, other indicators reveal a different picture. The ultimate safe haven and inflation hedge, namely gold, registered further gains above $1000 per troy ounce. That other safe haven, US Treasuries underwent the strongest demand in almost 2 years (bid-cover ratio 2.92) for the $12 billion 30-year note auction, whilst the earlier 10 year note auction also saw solid demand (bid-cover ratio 2.77) as well as strong interest from foreign investors.
The massive increase in bond issuance to fund the burgeoning fiscal deficit continues to be well absorbed by the market for now, whilst the drop in the dollar does not appear to be putting foreign investors off US assets. The strong demand for Treasuries could reflect a lack of inflation concerns but may also reflect worries about recovery, quite a contrast to the move in equities.
The fact that the Japanese yen and Swiss franc strengthened against the dollar also contrasts with the view that risk appetite is improving. The yen was the biggest beneficiary currency during the economic and financial crisis but has continued to strengthen even as risk appetite improves. USD/JPY dropped close to the psychologically important level of 90 last week which actually indicates a drop in risk appetite. Perhaps the move is more of an indication of general dollar pressure rather than yen strength.
A likely explanation for the drop in the dollar is that it is increasingly becoming a favoured funding currency, taking over the mantle from the Japanese yen; investors borrow dollars and then use it to take short positions against higher yielding currencies. US dollar 3-month libor rates fell below those of the yen and Swiss franc for the first time since November, effectively making the dollar the cheapest funding currency and fuelling broad based weakness in the currency.
Although the historically strong relationship between currencies and interest rates has yet to establish itself to a significant degree, ultra low interest rates suggests that the dollar will remain under pressure for a while yet, especially as the Fed continues to highlight that US interest rates are not going to go up in a hurry.