The US dollar: risk and reward

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. The MXN may at some stage share the same fate, particularly from H2 as the U.S. slows and investors prepare for the 2006 presidential elections. For "riskier" assets as a whole, the endgame may take some time to play out as the fundamental dynamics remain supportive for now. However, the increasingly violent corrections we are seeing in currency and asset markets may be a warning of what is to come.
Potential Triggers for Risk Aversion
Trying to forecast when the market will eventually move from risk seeking to risk aversion is like trying to pick the top in the NASDAQ in 1999-2000. A more constructive approach is to try and suggest likely triggers for an eventual reduction in risk appetite and the likely ramifications for global FX markets:

• The continuing risk in risk-free rates: The Fed funds target rate has so far been raised 150bps to 2.50%. Our base case is it will be raised to 3.25% by the June FOMC meeting and risks rising further. The Fed is trying to return to a "neutral" policy stance, but it may not know exactly where that is. The only way it can tell for sure is if there is sufficient market distress, which suggests there is a risk the Fed may tighten too much. In any case, risk-free interest rates may rise to a level which may cause general risk reduction

• Growth deceleration in the U.S. and China: The U.S. and China have been the two main drivers of global growth. At some stage, most likely in H2, those two economies will start to cool, hurting commodities and commodity-related currencies

FX Strategy - Reduce Beta
Any framework to prepare for a reduction in investor risk appetite should focus on vulnerabilities to 1/ higher U.S. rates 2/ a stronger USD 3/ a commodity price correction and 4/ a U.S./China slowdown. In anticipation of lower risk appetite, investors should look to reduce overall beta within their FX portfolios, favouring those currencies with low USD debt, strong C/A surpluses, a good
balance of domestic- and externally-led growth and low dependency on specific commodities or countries. The most obvious vulnerability is C/A balance deterioration but debt levels may also become important.

• Leveraged funds: Look for opportunities to sell stretched G10 currencies against the USD, particularly from H2, using options to achieve best reward/risk ratio. Favour Asian currencies and the BRL over EUR, GBP, AUD, NZD, the ZAR and MXN

• Real money funds: Continue to favour overweights in Asian currencies relative to benchmark and also in the BRL. Reduce overweight in the EUR - effectively making one short EUR-Asia - and start to scale into underweights in the likes of AUD, NZD and GBP. Balance overall exposure
with a weighting in lower yielding currencies such as SGD and JPY with high current account surpluses

• Corporates: USD-based corporates should be looking to increase their hedging ratios against the G10 currencies, the TRL, MXN and ZAR. EUR-based corporates should look to be reducing hedging ratios against Asia and Latin America, but increasing them in Eastern Europe. Finally, Asian-based corporates should be looking to increase significantly their hedging ratios against the EUR, GBP and AUD

Callum Henderson, Head of FX Strategy