>U.S. Dollar Drowning In A Sea Of Liquidity (WELLS FARGO LIMITED)

Summary: The greenback has been especially weak in 2009, falling by 15% on a trade-weighted basis since March. However, we view the dollar’s fall as more cyclical than structural. Instead, we believe a massive injection of liquidity by central banks has supported equity and commodities markets, and related commodity and emerging currencies, at the expense of the greenback. For 2010 we expect a reversal of these trends, leading to a less favorable outlook for major currencies as well as commodity currencies against the dollar. The greenback’s trend in 2010 should be higher despite - or perhaps because of – this year’s decline, and we would still suggest formulating hedging and investment strategies around a stronger dollar outlook for 2010.

Why Is The Dollar So Weak?
From its most recent major peak in March of this year, the trade-weighted value of the greenback has fallen by 15% against other major currencies. The dollar’s decline has been accompanied by repeated calls of a terminal demise in the dollar. However, we believe that the greenback’s fall is more temporary than permanent, and that the structural factors often cited for the dollar’s decline have played only a limited role. Of particular relevance to this debate, we note:

• Although the double-digit U.S. government budget deficit is historically large, it is nonetheless
comparable to other major countries (U.K., Japan). Moreover, gross government debt levels for the overall U.S. public sector are similar to the U.K. and Germany, and well below Japan.

• We see little risk of runaway inflation undermining the dollar (or indeed any other major currency). Low capacity utilization rates and high and rising jobless rates will restrain cost pressures in the near-term, while we doubt the world’s central banks will allow inflation to become entrenched over the medium to longer-term.

• Foreigners (both the private sector and central banks) are still buying Treasury bills and bonds, albeit at reduced pace ($287B in the past six months compared to $490B in the second half of 2008 – see chart, top right). That said, the most recently available figures do point to a fall in the proportion of the world’s FX reserves held in dollars.

Instead, we believe much of the greenback’s 2009 fall is of a cyclical nature. In particular, we believe a massive injection of liquidity by global central banks, along with other economic stimulus measures by global governments, has played a large part in the dollar’s fall. The chart below shows recent liquidity trends across the OECD region, which includes all of the major developed economies. Narrow money growth across the OECD has accelerated significantly in recent months, reaching 12.9% y/y in August. In part, that acceleration reflects the very stimulative monetary and liquidity policies of central banks like the Federal Reserve, Bank of England and European Central Bank.

In contrast, growth in broader money measures has actually slowed significantly in recent months, to just 6% y/y by August 2009. These broad money aggregates reflect not only the actions of central banks, but also the actions of commercial banks and other financial institutions operating within an economy. The fact that broad money growth is slowing even as narrow money measures accelerate suggests that the cash injected by central banks into the banking system and money markets is not circulating around the economy as one might typically expect. In turn, that reflects greater caution on the part of commercial banks in the wake of the global financial crisis with lending activity still very subdued. For example, total outstanding loans and leases by U.S. commercial banks are down 4.2% from a year ago, while in the Eurozone loans to the private sector are up just 0.1% over the past year.

The contrast between accelerating growth in narrow money and slowing growth in broad money is particularly interesting and relevant for FX markets at the current juncture. The cautious approach by banks suggests that central bank actions are providing only moderate support to the broader economy, and consensus 2010 GDP growth forecasts for the major regions are subdued (around 2½% for the U.S., and just over 1% for the Eurozone and Japan). Instead, much of this ‘new’ liquidity appears to be finding its way into a range of asset markets: emerging market government bond spreads to U.S. Treasuries have narrowed to around 300bp (from around 865bp at the peak of the crisis), the CRB commodities prices are up 40% from their low, and global equities markets have surged 55% from their low point – a much stronger rebound than current or prospective global GDP growth might suggest.

Related currencies have benefited at the expense of the U.S. dollar. The commodity sensitive Australian and New Zealand dollar are both up around 30% year-todate, and have started to close in on pre-crisis peaks. Among the emerging markets, the Brazilian real (34%) and the South African rand (26%) have enjoyed particularly large year-to-date gains. 2009 has also been characterized by an especially prominent correlation between stronger equity markets and a weaker dollar as funds have been diverted towards these asset markets.

Central Bank Actions A Key 2010 FX Driver
This relationship between global liquidity, global asset markets and the U.S. dollar is likely in our opinion to remain a key theme for the foreign exchange market during 2010. As we move further away from the peak of the global financial crisis and the trough of the global economic recession, central banks (and governments) will start to remove some of the stimulative policy measures put in place over the past couple of years. This policy tightening is not necessarily designed to restrain growth or head-off inflation, but rather to remove ‘emergency’ measures that are no longer appropriate as financial markets show some stabilization, and as economies show a return to growth. The trend towards less policy accommodation has only just begun with a rate hike from Australia earlier this month and with a rate hike expected from Norway later this week. But this trend should gain momentum through 2010, with the major global central banks expected to start hiking rates from around the middle of next year.

To see the full report: U. S. DOLLAR