The greenback is back

London (Mar 2)  A recent reversal of fortunes for the US dollar has been built on the back of revolution in Ukraine and a rethink on emerging markets in the face of an uncertain outlook for global economic growth that has temporarily driven investors towards safe havens.

At least that is what dollar bears would have you believe - especially those still betting on further falls for the greenback after a decade of steep and steady decline.

The real risk for investors holding short dollar positions is that a temporary wave of risk aversion turns instead into a secular recovery - one driven not by supposedly unstoppable market forces, but by the real power brokers in currency markets: central banks.

Forget safe-haven fillips, fundamental forces are working in the dollar's favour and the up-wave is decisively engaged.

Since the advent of floating exchange rates in 1973, the dollar has moved in long-term cycles. Periods of cyclical rallies would be followed by periods of cyclical declines - some shorter than others, some longer.

The five-year cycle leading up to the G7 Plaza Accord in 1985 was a prime example. The dollar rallied 50 per cent, until the G7 stepped in and capped its rise. It then lost 40 per cent of its face value in the next five years. It was an act of grand design, an official response to market forces that had got out of hand and needed a correctional touch on the tiller.

Powerful central banks like the US Federal Reserve and the Bank of Japan eventually get their way on exchange rates. The hegemony of market forces is a myth.

Look at the period following the collapse of the dotcom bubble in 2000 and the subsequent 2001 recession. US policymakers pulled out all the stops to reflate their ailing economy. They eased fiscal policy, slashed interest rates and, critically, cut loose on the dollar.

The Fed would never admit to any explicit dollar policy target. But the dollar's 40 per cent slide over the following six years was a gambit to reverse the loss of US manufacturing jobs haemorrhaging overseas to cheaper production centres, especially Asia.

During the 2008-09 crash, the Fed opened the monetary floodgates to quantitative easing to stop the slide into Armageddon. Once again the dollar was deliberately put in play to help engineer a recovery.

Success seems to have justified the means. The weaker dollar is winning jobs back to the US. Exports are booming. Latest GDP data shows export growth running at an average annualised 10 per cent in the past two quarters.

US policy actions are already working in the dollar's favour, but viewing the greenback in a more positive light is tough considering how gloomy the backdrop for the currency has been for so long.

Dollar bears have had a field day in an environment in which they could claim that quantitative easing debased the dollar, compromised its status as the world's premier reserve currency, and ultimately cost it its cherished AAA credit rating.

Yawning budget and trade gaps and the risk of government default looming large only added to this blinkered view.

But with the US economy showing stronger signs of life, arguably the policy of "benign neglect" towards the dollar has had its desired result.

A gradual normalisation of US monetary policy will only offer further support to the currency. Fed tapering will return the dollar to terra firma as surely as quantitative easing pulled the rug out from under it.

Relative rate dynamics will also help. Widening interest rate and bond spreads should be very dollar-supportive. Fed tightening will precede the European Central Bank and Bank of Japan by a long stretch. And once the Fed starts to offload its US debt holdings, rising long-term US yields will act as a magnet to dollar bulls.

Relative growth differentials should work in the dollar's favour too. The US economy is far ahead in the recovery stakes and should be on course for underlying 3 per cent growth next year. The euro zone is still flirting with recession, while sustainable recovery still seems a long way off for Japan.

Progress is being made to correct structural imbalances. US lawmakers are addressing the burgeoning budget. The trade deficit is also shrinking, helped by the country's growing energy independence, thanks to the shale gas revolution.

The vibrancy of US merger and acquisition activity and the bullish mood in the equity markets will continue to pull in strong capital flows, adding further zest to the dollar.

Seen in that context, recent safe-haven demand for dollars is merely a bonus for bulls already anticipating a long-awaited dollar renaissance.

Source:  SCMP