Strong dollar should be seen as a warning

THOUGH yesterday saw a broad market rally, it was a tiny chink of light in an otherwise dark tunnel for the economy. The ongoing Eurozone debt crisis and the seeming inability of anybody involved to take hold of the situation with a credible plan for managing the fallout of an inevitable Greek default has driven flight into the dollar. These capital flows have also been driven by a slew of sickly world macro data and slashed forecasts.

“Typically viewed as a ‘safe haven’ currency, dollar strength is more often than not a sign of increasing risk aversion,” says Jana Pristovsek, market analyst at IG Index. “With Greece hovering on the brink of a default and the Chinese economy seemingly about to stall, investors will be looking to protect their wealth ahead of a potential storm.”

The dollar has risen, commodities have fallen further than can be attributable to dollar firmness. Risk assets have fallen into ever closer correlation. All of which should have those with positions in the highly volatile forex markets sitting down and concocting plans for a possible collapse.

COMMODITY CURRENCIES HIT
Dollar strength has triggered a shift away from a “world economic crisis” consisting of the Eurozone, the UK and the US and instead threatens a genuine world economic crisis. In recent months, the to and fro between Eurozone arguments and US debt ceiling bickering has dominated the forex markets. But as the dollar continues to rise, it is dragging more and more economies into the turmoil. Investors have been driven by risk aversion into the greenback – perceived by many as the only safe fiat currency. These inflows have seen the dollar strengthen against its major pairs and also affected dollar-denominated commodity prices (see commodity ETF chart, below right)

A strong dollar, coupled with a slew of cuts in global growth forecasts, has hit the exporting economies of resource-rich countries hard, with their currencies taking a hit as a consequence. The Aussie, Kiwi and Canadian dollars have all tumbled this month – the Australian dollar being particularly hard hit. These commodity currencies – those of countries which depend heavily on commodity exports – had been holding up well for the last quarter, seemingly disconnected from the turmoil in the Eurozone. But dollar strength has put a stop to this run.

But why have investors been driven into the dollar? “Dollar is the most liquid currency on the one hand being exchangeable at any time, and on the other hand, the US has a monopoly on printing the dollar,” says Yoni Assia, chief executive of eToro. “The combination of the two makes the US debt, especially in the short term, the safest deposit.”

REAL MONEY
Following the Swiss National Bank intervention at the start of the month to put a €1.20 floor under the euro-Swiss franc price, one might have expected risk-averse investors to flood into gold, as had been the trend for the last 18 months. But the fall in gold at the tail end of last week was the biggest decline seen since Jimmy Carter was in the White House.

This is not entirely attributable to a strong dollar. “Last week, the dollar index was up 2.5 per cent, although we only have to go back to two weeks ago to see a greater increase of 3.3 per cent, during which gold only fell 1.4 per cent,” says Simon Smith, chief economist at FXPro. Smith also observes that while the gold price has declined, there has been a lack of reaction in the gold holdings of gold ETF funds, which suggests that retail investors are sticking with gold, or at least aren’t liquidating it in large volumes – the decline has more to do with institutional investors pulling out of long positions elsewhere. “Fundamentally, the fact that gold is having such a torrid time when global real interest rates are near zero is indicative of the extreme risk aversion that is currently being seen.”

HISTORY REPEATING ITSELF
As economic crises of one form or another surround all of the world’s largest economies, many will be drawing the inevitable comparisons with market movements in the run up to the 2008 market implosion.

In August 2008, the dollar rallied strongly, as it has done shortly before the majority of serious market crashes. Shortly after the dollar rally, the equity markets caved in. With this in mind investors should be asking themselves right now if the strong dollar is really the canary in the mine shaft and if they should be positioning themselves accordingly.