Irrational Exuberance

It seems to be the time when the dollar has begun to defy laws of gravity again. During the last decade, the dollar defied laws of economics and stayed buoyant in spite of a huge and ever widening current account deficit. Now, the US economy is in the dumps, interest rates are being rolled down, banks are going bust, stock markets are down….there is widespread econo-panic from the Wall Street to the real street, and yet the Dollar seems to be soaring!! Isn’t this irrational exuberance?

However irrational the rise of the dollar may appear a rational grounding that is explainable in plain economics must be found. The irrational exuberance of the US dollar can be blamed on the current psyche of ‘risk aversion’. Risk aversion amongst US investors is making them dump their investments in other markets and repatriating them back home. This implies that a US investor, who held securities in nations like Australia, India etc. are selling those and exchanging the local currency proceeds for dollars to bring them back home. This is leading to a sudden surge in demand for the greenback and making it appreciate. As per available Treasury Department data, US investors sold $57 billion more in foreign bonds and stocks over their purchases in July and August this year. The last three months have witnessed a 20% jump in the dollar index, which is a measure of the dollar against a trade weighted basket of six key currencies.

The US dollar by default is also the global reserve currency as majority of global central bank holdings are still in US dollars, most of oil trade is in US dollars and also a majority of other international trade is also dollar denominated. This seems to provide a sense of security to the global investor fraternity and they trust the US dollar as the best bet in times of crisis. This implies that not only are US investors getting their dollar back home, but investors in other nations are also scurrying to sell their own currencies and converting them to safer holdings in US dollars or US treasuries. The US dollar in this case seems to be a victim of ‘global de-leveraging’.  Treasury Department data suggests that holdings in US Treasuries jumped by about $ 100 billion in the past 30 days!!
The future of this trend is going to depend upon how the fear factor and risk aversion play up. This is dependent upon future economic performance and the rescue packages that various governments are in the process of implementing. As per latest reports, credit markets that had glaciated have begun to thaw to some extent, which is indicative in easing of the LIBOR. The rate for borrowing Euros fell to 4.96% or the pre Lehman collapse levels indicating that inter bank borrowings were easing and that rescue packages had begun to take effect. A gradual healing of the global economy could make investors start buying securities and reverse the trend for the dollar.

However, the global economy seems to be badly wounded and any further bad news can make things go worse and could derail the healing that has started. Such derailment could result in a flight to risk aversion and could spike the dollar further!!  

What do you think? Feel free to leave a comment below or discuss with others in the Forex Forums!