It'll be the year of the greenback

Far from receiving its last rights, the US dollar has gained solid support in global financial markets over the past two months. Indeed, the flow of money channelled into dollar markets has grown as financial cracks widen in the world's main traded currencies, such as the euro and sterling, and particularly linked to sovereign risk.

Much of the momentum in the upward rise in the US dollar is strongly correlated to sovereign risk factors. Here, markets and investors are seeing a relatively safe haven in the greenback. The rise in the dollar against a basket of the main traded currencies has been above 10 per cent since the beginning of 2010. The outlook for the dollar for the remainder of 2010 is good, especially for the first half of the year, and overall 2010 may well turn out to be the year of the greenback.

The tide has turned against those believing the dollar would continue to see a downward slide, with the currency losing its status as the global yardstick. There have been increasing long positions taken by investors and traders for the dollar since the beginning of the year, in contrast to the previous two years, and specifically the final six months of 2009. Aggressive selling of the euro and sterling continues, with sporadic pullbacks, and this is likely to continue as nervousness for both currencies going forward is large.

The euro's very status as the primary alternative to the US dollar makes it particularly vulnerable to weaknesses and or threats attached to the eurozone economy. Its own economy is vulnerable to uncertain economic growth and financial recovery, high unemployment and weak consumer and business sentiment. On the back of this, the European Central bank is unlikely to raise interest rates throughout 2010.

The market was of the belief that the US would continue to see long-term structural outflows from global reserve managers aiming to diversify their foreign exchange reserves. Much was earmarked for the euro as it gained in strength and credibility. However, the euro's stability and credibility has been hit by a number of factors, including the sovereign debt profiles at member states , in addition to weak economic growth in Germany, the eurozone's largest economy. There are many challenges for the euro as it must agree on a creditable rescue framework for Greece as well as manage other member states own debt positions. Moreover, economic growth in the eurozone is weak with the probability of a double-dip recession growing. The US dollar will continue to remain a good hedge against eurozone weakness in 2010.

The other factor which is supporting the dollar's underlying strength is the outlook for the US economy. Although still some way to go, the US economy is beginning to show firmer signs of a sustained economic recovery. Many recent economic indicators in the US have been positive and, as economic data has improved, real interest rates in the US have become more supportive for the greenback. The performance of US Treasuries is also supporting the dollar.

The US dollar outlook will also be dependent on some key factors, including the underlying risk environment vis-a-vis financial markets and economies. Here, the US dollar is still a safe haven in times of uncertainty and will continue to benefit as the global economy navigates challenges from uncertain growth direction to sovereign pressure to asset bubbles in markets such as China. Additionally, far from losing its position as a main funding currency, wholesale debt issuers are still focusing on the dollar as the first currency of denomination.

Relative interest rate expectations are also key to the dollar's movements going ahead. At some point, US interest rates will begin their upward rise. The US central bank has recently raised the so-called discount rate from 0.5 per cent to 0.75 per cent. The change was the first move in US interest rates since December 2008, when the bank lowered the discount rate to 0.5 per cent.

The increase widens the spread between federal funds and the discount rate to half a percentage point, the upshot of which will be to encourage banks to borrow from the short-term credit markets rather than using the Fed – until this decision the cheapest source of short-term funding. The Federal Reserve said the change is not expected to lead to tighter financial conditions for households and businesses. However, it is a precursor to moves to raise interest rates more broadly in the future, most likely in the second half of the year. As the market moves closer to this time, and with the first rate hike, dollar momentum is likely to increase.

As mentioned, the US economy is beginning to show recovery. Manufacturing data is seeing some shoots of recovery. The US economy expanded more vigorously than previously thought in the fourth quarter of 2009, showing its biggest rise in six years. The upward revision was driven by positive contributions from business investment and inventories, but consumer spending was less than originally thought. The fourth-quarter figure compares with 2.2 per cent growth in GDP in 2009's third quarter, lifting the US economy from recession after four quarters of contraction. For the full year of 2009, GDP fell 2.4 per cent, the biggest full-year decline since the 10.9 per cent recorded in 1946.

Also supporting the dollar is the fact that many countries' currencies are still linked to the dollar. This is the case for most Gulf economies and many other markets, including China. This link is likely to continue for some years and hence will support the dollar.

- The author is a US-based commentator on business issues. The views expressed are his own.

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