The US dollar: risk and reward (page 1 of 2)

Risk and Reward
Global markets remain firmly in "risk seeking" mode. To confirm this, we use the VIX index of S&P 500 implied volatility, EMBI Global and 10-year U.S. swap spreads and the CRB commodity index. These reflections of risk appetite have been in "risk-seeking" for some time. The VIX is currently trading around the lowest levels seen since 1995, the EMBI Global and 10- year U.S. swap spreads close to multi-year lows and the CRB is at major highs. As a result, higher-yielding and "riskier" currencies have outperformed significantly. From an investment perspective, there have been 4 main drivers of this:

• Policy and market interest rates remain historically low: The Fed is "normalising" monetary policy. However, the Fed funds target rate of 2.50% remains well below the 6.50% rate at which the Fed began its easing cycle from the start of 2001. U.S. Treasury yields have corrected higher after a series of strong U.S. numbers, but the long-term yield downtrend has not yet been broken

• Previous policy stimulus has generated abundant liquidity: The past monetary easing cycle, together with huge U.S. fiscal easing has generated massive amounts of global excess liquidity, which in turn has resulted in asset market inflation and out-performance in "riskier" assets

• A secular improvement in Emerging Market (EM) macroeconomic dynamics: Past currency crises have encouraged EM policymakers to pursue more prudent economic policies, tightening fiscal policy, reducing foreign debt, improving asset-liability management and sustaining a disinflationary trend. The result has been a sustained improvement in EM
balance of payments

• "Crossover" buying: Investors who are benchmarked to G10 stock and bond indexes have become more active in diversifying into "off-index allocations" due to lower benchmark returns and available "alpha" in nonbenchmarked assets. The secular improvement in EM fundamental
dynamics has accelerated this. In addition, EM assets are increasingly becoming integrated to standard industry benchmarks, creating so-called "blended benchmarks"

From an FX perspective, this risk-seeking environment has been reflected in broad USD weakness since 2002 and multi-year out-performance by higher-yielding G10, commodity and EM
currencies. From the start of 2002 through March 1, 2005, the top performing currencies against the USD have been the ZAR (+103.45%), NZD (+74.23%), ISK (+69.39%), SKK (+68.20%) and the BWP (+59.86%).

Increasing Signs of Market Distress
In 2003 and 2004, USD weakness was expressed largely through appreciation in the major currencies, such as EUR, GBP, AUD and NZD. As a result, the Australian and New Zealand current account deficits are running at around -7% and -6% of GDP, the UK current account deficit has hit the highest level since 1999 and the Eurozone basic balance looks set to deteriorate sharply. The speculative cycle model of exchange rates (Soros 1987) suggests that FX trends persist until fundamental deterioration reaches a tipping point whereby real money (investor and corporate) out (in) flows overwhelm speculative in (out) flows. The period ahead of that is typified by increasingly violent corrections in the currency, which climax in an eventual trend reversal. We believe we are in this endgame in AUD, NZD and GBP and eventually EUR as that basic balance deterioration becomes more evident.

Within EM, the ZAR stands out as a currency whose explosive gains may be retraced to some extent later this year given the deterioration in South Africa's current account deficit.