“Since the bursting of the tech bubble in early 2000, the dollar has been inversely correlated with risky assets,” says a research note from BCA Research. “However, the recent weakness in the dollar is at odds with the historical relationship.”
Notwithstanding the sharp declines on global stock markets and surge in volatility, the dollar has not strengthened and the trade-weighted dollar index remains near multi-year lows.
According to BCA Research there are three key reasons why the dollar strengthens during times of financial stress:
(1) global capital flocks to the safety of U.S. Treasuries,
(2) U.S. investors stop sending their savings abroad (and even repatriate capital), and
(3) the U.S. trade deficit narrows during recessions.
“This time around, however, the safe-haven factors have not turned in favor of the dollar thus far, even though it is premature to make definitive conclusions due to data lags. U.S. macro policies are the obvious reasons for the dollar’s diminishing role as a refuge: fiscal policy is a mess and the Fed is committed to devaluing the dollar.
“While economic policies outside of the U.S. are hardly picture perfect, foreign exchange is a relative game. Policies only have to be ‘less worse’ than the U.S. to win. Overall, the risks to the dollar are becoming increasingly asymmetrical.
The report concludes that reflationary U.S. policies will weaken the dollar with diminishing support coming during periods of “risk off” and recommends shorting the greenback.
Source: BCA Research – Daily Insights, August 23, 2011.
