What Can Save The Dollar?

The dollar's weakness over the past several months has been directly related to the modest net capital outflows from the United States, most of these outflows came from the domestic banking sector, and the strength of the U.S. equities markets. Some of these outflows are the results of an unwinding of the panic-driven inflows of last autumn, which was a great period of dollar strength. Both foreign purchases of U.S. Treasury bills and dollar liquidity surged when the global financial system was on the cusp of collapse, and there was a flight to safety.

Investors have now been liquidating their holdings of safe, but low-yielding, T-bills over the past several months in favor of higher rates of return that can be found in higher yielding foreign countries, emerging markets, and the domestic equities markets. Also, net purchases of long-term U.S. securities has decreased due entirely to fewer foreign purchases of agency securities and securitized assets. Lastly, the majority of the net capital outflows are a result of a substantial increase in foreign lending by U.S. banks, totaling nearly $300 Billion in the last 4 months.

What can reverse the dollar's recent slide?

There are several developments that have the potential to lead to a stronger dollar. First, a return of risk aversion among investors would lead to higher foreign purchases of U.S. Treasury bills and a reduction in U.S. bank lending to foreign borrowers. Another fundamental change that can produce sustained dollar appreciation would be an increase in rates of return on U.S. assets. This increase in U.S. interest rates would be signaled early by a run of stronger-than-expected U.S. economic data, which would raise hopes that the recent bounce in U.S. economic activity will turn into a sustainable recovery. Higher rates of return on dollar assets from an increase in interest rates usually attracts capital inflows that lead to dollar appreciation.

Technical factors are against the dollar at the moment, including a weakening trend. If the dollar index can print a weekly close above the $76.50 level, which it is very near, this will be a signal technically for more dollar strength. This level would signal a change in the trend, and a break of significant resistance levels, which would lead to strong dollar short covering. Dollar risks remain if indications arise that the United States is not serious about addressing its fiscal challenges, which could be the catalyst that causes foreigners to significantly reduce their purchases of Treasury securities. Currently, we believe that conditions are shaping up for some good medium term dollar strength.