US' $805-bn trade deficit hurts greenback's safe-haven status

NEW YORK: Prospects for a prolonged period of risk-aversion stemming from the recent volatility in global markets could be bad news for the dwindling ranks of dollar bulls. Not so long ago, the dollar benefited during periods of diminished enthusiasm for risk, buoyed by its status as the world’s preferred reserve currency.

Now, though, the dollar is rapidly losing that safe-haven status thanks to an ever-growing US current account deficit, and more recently a vague, often conflicted monetary policy from the Bush administration.

Instead, investors are turning to currencies with robust current account surpluses such as the Swiss franc (CHF), Norwegian crown (NOK), Japanese yen (JPY), and Canadian dollar (CAD).

Recent concerns that the global economy may be on the brink of a high-inflation, low-growth scenario fuelled a flight away from risky assets, analysts say. At the same time, uncertainty surrounding major central banks’ interest rate decisions and the continued withdrawal of global liquidity have contributed to an increase in market volatility.

“The dollar cannot be a beneficiary of higher risk aversion because of the high US current account deficit and high valuations,” said Jens Nystedt, currency strategist at Deutsche Bank in New York.

Current account is a measure of international trade, in physical goods and international transactions. The roughly $805-bn US current account deficit at the end of ’05, equivalent to more than 6% of GDP, has contributed to dollar weakness in three of the past five years.

US monetary policy isn’t helping, either. The minutes from the Federal Open Market Committee’s May 10 meeting depict a Federal Reserve torn over how to properly balance quickening inflation and slowing economic growth. That ambiguity has deflated confidence in the dollar, exacerbated market uncertainty, and elevated risk aversion.

Some support from short covering

One of the few supports the dollar might find in a such a risk-averse environment is if investors overextend positions against the currency.

“The market is very short dollars, and people are favoring a weaker dollar anyway,” said David Greenwald, a partner at short-term currency hedge fund Scalene Capital Management in Newport Beach, California. “So if people are forced to cut their losses, they may be forced to reduce some of their short dollar positions.”

This played out last month when the dollar, weighed down by a bevy of short positions — or bets it would weaken — rallied in conjunction with a big sell-off in risky asset markets, such as stocks and dollar-denominated commodities. During that tumultuous stretch, the dollar regained some footing.

Over the three weeks from May 11, when a sharp drop in US stock markets triggered a global flight from risk, through May 31, the dollar strengthened by nearly 0.5% against a basket of major trading partner currencies, halting at least temporarily what had been relentless dollar selling.

Depending on the barometer, most risk aversion gauges have eased in the last few days, but they remain elevated. One, the UBS risk index, is still in “risk-averse” territory.

Most analysts expect risk aversion to remain high. “The possible pause from the Fed to be followed by a period of uncertainty about future changes in rates as policy-makers watch how the data breaks has the potential to lead to somewhat more volatility,” said Stephen Gilmore, executive director and emerging market strategist at Banque AIG in London.

For instance, implied volatilities on euro/dollar options, which measure how much the market thinks spot prices will move over a given time frame, spiked to around 9.08 on Monday, from about 8.60 last Friday.

Also, poor returns by hedge funds during May’s chaotic run are likely to make managers of these pools of wealth wary of risk.

Hedge funds gave up about three quarters of their 2006 gains during May’s rout, according to the Calyon Financial Index, which measures the daily rate of return for a pool of selected commodity trading advisers. The index showed a negative rate of return of about 1.1 percent as of May 30.

Analysts say most hedge funds are currently on the sidelines waiting for the dust to settle in financial markets.

“I think there’s a lot of reasons to be risk averse — I guess people had been burned a lot this year,” said Scalene’s Greenwald. “Those that have profited may be interested in protecting some of their profits and those that did not (profit) may be trying to make sure that they don’t dig a too deep a hole,” he added.

Yet even when the storm passes in the market, the dollar is unlikely to get some support, analysts say. “Increased focus in public debate on the risks posed by the large U.S. external imbalance appeared to erode investor support for the dollar,” said Axel Merk, manager of the Merk Hard Currency Fund in Palo Alto, California.