NEW YORK, 20 August 2007 — Investors’ flight to safe haven assets to escape the global credit and liquidity squeeze of the past week has given the US dollar a reprieve from a long-term decline this summer, but capital flows suggest the greenback’s weakness will resume when the dust settles.
As easy-financing conditions dry up on signs that losses in the US subprime mortgage market are being felt as far away as Europe and Canada, some US domestic investors have begun to bring money back home from overseas, providing support to the dollar.
However, a close look at cross-border capital flow data shows the US dollar will probably resume a broad-based decline before long.
“You’ve seen in the initial wave some US selling of foreign equities to shore up balance sheets,” which has helped to push up the dollar, said Parker King, chief investment officer of the currency investment unit at Putnam Investments in Boston.
“When all this normalizes, you’re going to be back to a dollar negative environment that is both fundamentally and structurally driven,” said King, who oversees a $36 billion portfolio.
For now, despite news last week that the largest French investment bank BNP Paribas froze around $2 billion in funds exposed to US subprime mortgage debt, investors last week placed a net $10.9 billion in fresh money into US equity funds, the largest weekly increase since EPFR Global started tracking the data five years ago.
Foreign flows into US-domiciled equity funds were $11.3 billion, while a net $361 million left non-US-domiciled US funds, suggesting that US investors were repatriating funds.
Furthermore, according to AMG Data Services, US equity funds took in a net $21.6 billion in the month to Aug. 9, the biggest monthly increase since the month to March 15, when once again a surge in risk aversion caused US investors to cut their foreign exposure.
These dollar-supportive flows may be fleeting though. Once the liquidity and credit storm abates, concerns about global economic and trade imbalances will weigh on the dollar again.
Brad Durham, managing director of EPFR Global, said periods of heightened sensitivity to risk in financial markets have lately been averaging about 20 weeks.
“The downturn is quick and sharp and the recovery period takes a little longer to stabilize,” Durham said.
The latest capital flow data for June, reported on Wednesday from the US Treasury, reflected a pullback in private investor demand for US assets, and an surge in official purchases, mostly from central banks, but this was prior to July, when the credit and liquidity problems began.
“In the past, declines in private inflows coupled with increases in official inflows often have been associated with dollar weakness and increased intervention to forestall currency appreciation against the dollar,” said Gabriel de Kock, an economist at Citigroup.
Foreign private purchases of US long-term securities slipped to $94.8 billion, down from $136.7 billion in May. Official purchases jumped to $53.8 billion, the most since March 2004, and more than double the 12-month average of $21.9 billion.
Even more revealing, if buying and selling of US short-term securities are included, central bank purchases of US assets made up 99 percent of overall net capital flows into the United States in June.
“Absent official demand for US debt, the US growth slowdown and the subprime crisis likely would have morphed into a dollar crisis,” said Brad Setser, an economist with RGE Monitor.
Though equity market flows into the United States have picked up this month, the over-arching trend remained of increasing US investor demand for foreign assets, another reason for dollar weakness.
Because of a gaping US current account deficit that is the equivalent of more than 6 percent of total output, the United States needs to attract $2 billion a day in foreign investment. Otherwise the dollar needs to decline and interest rates rise.
The average monthly net purchases of foreign assets by US investors rose 56 percent in the first half of 2007 compared with the first six months of last year.
In the short term, money managers and analysts attributed the dollar’s rise this week to 1-1/2-month highs against a basket of major currencies to the cashing in of bets on further weakness in the greenback.
A dealer with a US custody bank said bets on the euro, sterling and the Canadian dollar were stretched the most against the dollar prior to the havoc in credit markets.
When asked what currencies the dollar will fall against the most once the current period of risk aversion subsides, the dealer said, “The euro, sterling and Canadian dollar.”