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OVER the last two months, the US dollar has managed a decent recovery, buoyed by hopes that the US economy was going to be the first out of recession, and therefore require the US Federal Reserve Bank to raise interest rates. This, at a time when their counterparts in Europe and Japan are more likely to contemplate rate cuts. In Q2 2008, the US economy grew a sparkling 3.3 per cent, thanks to some US$110 billion in tax rebates as well as the stronger exports facilitated by the weaker US dollar earlier in the year. In sharp contrast, the UK economy flat-lined, Japan’s fell sharply, and those in the eurozone tanked too.

Since then, however, US financial giants have fallen like tenpins, starting with Fannie Mae and Freddie Mac, then followed by the collapse of Lehman Brothers and the Fed bailout of insurance giant AIG this week. Worse, bluechip stocks tumbled the best part of 4 per cent on Wednesday night, rattled by fears that there’ll be more to come. In response, the search for safe refuge alternatives saw gold recording its largest ever one-day rise, exploding almost 10 per cent higher overnight, the Japanese yen and Swiss franc topping overnight currency gains, and short-term US Treasury securities bought despite near-zero yields.

Based on a broader-based US dollar index, however, the greenback is still some 10 per cent above its all-time lows of March 2008, although key Wall Street indices have fallen more than 25 per cent off their all-time highs of 2007 - to lows not seen in three years or more. This is possibly due more to a short-term technicality than true US dollar resilience. It happened in July this year, and is happening again this month, as risk aversion and flight to safety considerations take centre stage. In short, US investors have sold - or are hurriedly selling - more of their overseas investments, and repatriating the proceeds. This requires them to sell foreign currencies in favour of the US dollars that they then send home - either into the safety of US Treasuries or to patch up losses sustained on the home front.

The same thing happened in July this year, the latest month for which such flow statistics are available. July’s net flow of funds only just managed to register a small plus (in favour of inflows into the US) because of massive repatriations. We’re told that Fannie Mae and Freddie Mac losses may have helped persuade - or force - US investors to bring home the proceeds from the sale of some US$14 billion worth of foreign bonds and US$18 billion worth of equities.

Given Wall Street’s huge losses, and the massive deleveraging we are witnessing, it shouldn’t be a surprise that US-based hedge funds have cut and run again - especially when they have to report Q3 results by end-September. Thereafter, they can put on new trades, and perhaps only then will the US dollar see its mettle truly tested.

Source : Business Times - 19 Sept 2008