Fears aside, U.S. dollar best in a bad neighborhood

By Wanfeng Zhou – Analysis

New York (BestGrowthStock) – In just a few months, the market’s perception of the U.S. dollar has turned 180 degrees.

Last year, the world was worried about a dollar crisis as the ballooning U.S. budget deficit sparked fears the greenback may lose its status as the international reserve currency.

In recent weeks, however, the dollar woes have been overshadowed by fiscal instability in Europe and problems elsewhere. Against a basket of currencies (.DXY: ), the greenback has gained more than 9 percent since its lows in November.

Many analysts expect the dollar to stay firm against most currencies this year. While the U.S. deficit is still large, prospects for recovery appear better in the United States than in Europe and Japan. That, along with the uncertainty surrounding the euro zone, should boost the attractiveness of the greenback as an investment.

“The fiscal negatives are a lot less from the United States now than what they were a year ago,” said Aroop Chatterjee, currency strategist at Barclays Capital in New York. “Sovereign risk is less of an issue for the dollar and more of an issue for the euro area.”

Sentiment has turned to such an extent that the dollar was not hurt by recent data showing China sold a record amount of U.S. government debt in December — news that would probably have pressured the currency in the past.

FAR FROM ROSY

To be sure, the U.S. fiscal deficit, which is projected this year to hit $1.56 trillion, or 10.6 percent of gross domestic product, remains a negative influence. Many U.S. states, such as California, also face difficult budget decisions.

But economists say it’s not the absolute level of U.S. debt that matters, but rather its relative position. With the euro zone, UK, and Japan all plagued by soaring government debt, the dollar’s resilience reflects a realization that it’s simply the best of a bad bunch.

There’s also scope for improvement on the U.S. fiscal front, especially if the recovery is stronger than anticipated, which would reduce further stimulus spending and boost tax revenue.

Nick Bennenbroek and Vassili Serebriakov, currency strategists at Wells Fargo, said data in the last 30 years do not show a “reliable statistical relationship” between budget deficits in the Group of 10 rich countries and their exchange rates.

During President Ronald Reagan’s first term in the early 1980s, the rise in the budget deficit didn’t hurt the dollar, which was supported by a tighter monetary policy and higher domestic interest rates. Conditions are different now, obviously – monetary policy is looser, rates are lower, and deficits are even larger.

THE TURN IN LIBOR

If the U.S. recovery is sustained, rates – both those set by the Federal Reserve and market rates – may continue to help the U.S. dollar in the coming months.

Yields on 10-year U.S. Treasury note were at 3.614 percent on Tuesday, higher than those of 10-year German government bonds at 3.11 percent.

In addition, key short-term U.S. dollar rates now match yen levels in Japan. Months of lower dollar rates helped fuel so-called carry trades, where investors sold dollars to fund purchases in other currencies and assets.

The three-month dollar-denominated London interbank offered rate was fixed at 0.2519 percent Tuesday, compared with the yen-denominated 3-month LIBOR rate of 0.2531 percent. If dollar rates continue to rise, the yen will take a greater share of the funding trade that weakened the dollar in late 2009.

Since the fortunes of major world markets seem to have shifted for now, renewed economic weakness may still benefit the greenback, as a pullback leads to demand for U.S. currency.

“There’s a little more uncertainty about the global recovery, and that’s an environment where the dollar tends to do well,” said Sophia Drossos, co-head of global currency strategy at Morgan Stanley in New York. “The U.S. cyclical data is outperforming other major economies like the U.K. and Europe.”

Tony Crescenzi, market strategist and portfolio manager with PIMCO in Newport Beach, California, said with the euro in duress, global reserve managers will have no choice but to buy U.S. Treasuries because “there is no other bond market for the world to house its $8 trillion of reserve assets.”

While China sold some $34 billion Treasuries in December, it added a net $4.6 billion of long-dated Treasury bonds. Some analysts said this likely reflected falling safe-haven demand. Because of the crisis, China accumulated a long position of more than $210 billion in short-term debt by May 2009, according to the U.S. Treasury; it now has just $70.1 billion.

China’s move to the long end of the curve could be a sign of confidence in the U.S. economy. India, Singapore and Korea also cut short-term Treasury holdings, Treasury data showed.

Purchases of U.S. debt by foreign countries like China have helped keep U.S. Treasury yields low over the past years. Some investors fear waning interest from overseas would lead to a spike in U.S. rates and cripple the economy, but that has not happened.

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(Editing by Padraic Cassidy)

Fears aside, U.S. dollar best in a bad neighborhood