Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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Nothing brings out buyers like higher prices, and other short stories

by Mark Dow
July 15, 2009

This post is by Mark Dow

DXY, a dollar index, looks like it has started to break down. At my firm, Pharo, we have been whispering on the trading desk over the last two days that this was looking increasingly likely. The implications are positive for risky assets. Markets play a lot of tricks on investors, and you can’t be too certain of anything in times as unprecedented as these, but, to us, it looks like the short dollar trade is “on”.

DXY, last 12 months

Is there a fundamental reason for this? Not clear. However, I am pretty confident that if the dollar continues to sell off the way it has started to overnight and this morning, and Treasuries continue to weaken the way they have started to, the stories of debasing the currency and Chinese diversification and the like will bob right back up to the surface. So, there will at least be a fundamental ‘story’ behind it.

Personally, I always find it hard to put too much faith in these predominately bearish dollar stories when risky assets are doing well. And, almost inevitably, risky assets do well when the dollar sells off. The correlation between the dollar and risky assets continues to be very high. Here is a correlation matrix of some proxies, using daily observations over the past year.


In the first row and column of the table you’ll see DXY, the dollar index comprising a handful of G10 currencies. The other rows represent various and sundry risky assets—mostly EM currencies, the S&P, and EEM, the ETF for emerging market equities. CCN+ is the 12 month forward for the Chinese Rinminbi, since the forward moves much more in response to market impulses than does the spot rate, which, as all of you know, is tightly managed.

For the dollar to be negatively correlated to risky assets, DXY should be positively correlated the CCN+, negatively related to SPX, AUD (since the Australian dollar is quoted in terms of dollars per Aussie dollar), and EEM. DXY should be positively correlated to TRY (Turkish Lira), BRL (Brazilian Real), and JPY (Japanese Yen).

You’ll notice that all of the correlations have the expected sign with the exception of JPY. This is due to the residual influence of the carry trade and deleveraging process. Since the yen was the other heavily borrowed currency during the levering up phase that led to the crisis (though nowhere near as abused as the dollar in this regard), the yen is the only currency apart from the dollar that is regularly negatively correlated to risky assets. It is also worth pointing out that the yen is a significant component of DXY, and, were it not there the correlations between DXY and these assets would even be meaningfully stronger.

Why is the correlation high? The simple, stylized answer is that most investment funds, irrespective of where they are domiciled, are denominated in dollars. This will change over time, and will contribute to the unwind of the dollar overhang that I wrote about here last week, but until it does, when investors reduce risk they buy dollars and “bring their assets home”, and when they increase risk they sell dollars and put their money back to work across the globe. There is more to it than that of course, but, over short spans, this is the main driver.

DXY, last 5 years

Okay. So, where does the dollar go? The market intelligence that we have put together here at Pharo tells us that market positioning—especially amongst large hedge funds—is light. The choppy markets frustrated a lot of investors, and there is very little belief in any positive economic scenario from here (true or not, this is the consensus view). In response, hedge funds reduced their longs, cut their shorts and headed for the beach, protecting the gains that they have had this year. Prop desks on the street are also protective of the profits they have generated so far this year. After an experience like last year, people really seem afraid of “doing something stupid”. The implication here is that if markets do move up, cell phones on the beach will ring and performance anxiety will start. Traders will chase. If, by any set of miracles, the fiscal stimulus or whatever starts to throw off better-than-expected news, traders would catch themselves really wrong footed, and things could get ‘ugly’ to the upside. In short, people would be much more surprised with good news than bad at this juncture. This would lead the DXY meaningfully lower, probably back to the lows of last year.


  • Posted by MakeMeTreasurySecretary

    Off topic:
    I am visiting Europe. It seems like Europe is experiencing its first “real” recession in the last 30 years. For the first time I see large segments of the population being affected and downscaling – like the Germans taking shorter and cheaper vacations, the Brits cutting down on trips to their favorable pub, and the Italians staying home more. Other recessions were mostly on paper but, based on what experience and hear, this recession has a bite. Despite European social nets, a lot of people are worried and everyone talks about “the crisis”.

    I supsect that the powers that be in Europe are not too happy that the euro is so strong.

  • Posted by FollowTheMoney

    in my opinion, Dow10k is very unlikely as UE ticks up, consumer credit contracts and the global imbalances month after month continue to get more and more unjustified.

    if there is a rebound, long commodity stocks…but lets be real, how you have green shoots when U.S. consumers fear losing jobs and have large debts to pay back?

    additionally, structural imbalances remain…we can’t just go back to everyone living in giant mcmansions, driving large SUV’s and taking 5 star resort vacations monthly using the home as an ATM.

    Furthermore, what makes me more worried than ever is that the bubble we have now is the increase in public borrowing instead of private borrowing.

    it’s back to 07′, but just government borrowing insane amounts to hold things together. Dow 10K won’t be that attractive with national debt of 15T, that’s T not a B.

    in my view, thank the good graces of gov’t intervention, not fundamentals for Green Shoots that can’t prosper without true readjustment.

  • Posted by Ying

    “structural imbalances remain”

    The root of the problem is dollar as international reserve money. “Triffin dilemma” can’t be solved if US is not willing to give up its position on dollar. It has to run trade deficit in order to export dollar assets. In fact there is no saving glut, but dollar glut. The only sector that benefit from this arrangement is US global financial sector which they intermediate borrowing and lending in dollars at global scale. Without dollar as reserve money, they will lose their competitiveness.

    Does any one notice the recent asset allocation trend among international investors, pension funds? Most investors seem to have reduced dollar based assets and increased BRIC assets? This could be self-fulfilling process that will trigger even bigger dollar glut in the near future. In reality, US doesn’t need to worry about China. The real threat of dollar comes from the private sector,global investors, pension funds, mutual funds etc.

  • Posted by black swan

    The strength of the USD runs inverse to the strength of the stock market. If the market is up the dollar is down, and vice versa. Once the Gold Men have paid themselves those huge bonuses paid for with $12.9 billion in taxpayer money, laundered through AIG, they will dump their stock shares, the market will collapse and the dollar will firm. That will be the time to dump the USD and buy commodities and commodity currencies. We’ve seen this movie before, but this may be the last remake.

  • Posted by bsetser

    mark – a question: why aren’t there more euro denominated investment funds, given that the eurozone isn’t that much smaller than the us and the eu is a bit bigger? e.g. why is the “bringing money (home) — or really bringing money back into the currency of accout of the fund so it isn’t exposed to fx moves” effect stronger for the USD than the EUR?

  • Posted by Mark Dow

    There are many more dollar-denominated funds than euro-denominated ones. Many European investors buy dollar-based funds. Not many US investors buy euro-funds. Asian investors tend, overwhelmingly, to buy dollar funds. I am guessing this is related to the dollar’s historical position at the center of the global financial system. Over time this will change as the dollar becomes progressively less central. But it will take time.

  • Posted by D Gross

    I don’t think that actual money flows in and out of funds (e.g. pension funds, mutual funds, hedge funds) by international investors drives the correlation between the Dollar, Yen and stock markets.

    Daily volumes in FX dwarf daily purchases/redemptions of
    mutual/pension/hedge funds, and many of these funds (while nominally dollar-denominated) have non-dollar investments or currency hedges on. E.g., most hedge funds are Dollar-denominated but they are not necessarily dollar-based investments. Also, if you take a look at private flows in the TIC data over the past decade, you see that US private investors have been fairly steady consumers of foreign stocks (while private investors in Europe and Asia haven’t always been steady investors in US stocks).

    I think what were seeing is just FX market psychology. The FX market tends to stick with a trade pattern that works until it stops working.

    As Mark mentions, the old carry trade was to sell Dollars and Yen and buy other currencies, emerging markets, commodities and stocks. When markets are rising and risk taking is in fashion, speculators buy things paying higher yields or with higher betas and leverage up by financing these with low interest rate currencies (like the Yen) or currencies thought to be in “excess” supply (like the Dollar). This can also be done intra-region (e.g. borrow Pesos to buy Reais).

    The dollar is thought to be in excess supply because the managed exchange rate regime exporters (BRICs, GCCs, Asia) not only convert Dollar exports back into local currencies but absorb Dollar sales from speculators (in order to keep their local currencies from appreciating) and then sell some of those dollars out (for EUR, AUD, CAD, GBP, etc) in diversifying reserves. Also, currencies like Brazil and China manage their currencies against the Dollar, meaning a speculator wanting to go long BRL or CNY will usually be selling Dollars at the same time.

    While the Yen should be very important as a reserve currency (given Japan’s GDP, stock market capitalization, importance in global trade, etc ), almost every central bank is heavily underweight Yen due to its low yields. Instead, the CBs play the carry trade, buying an excess of currencies like the Aussie and Kiwi Dollars or the UK Pound while avoiding the Yen. This is not really rational behavior, and they got killed on this trade in the Fall, but they are suckers for yield, as are hedge funds. The thinking is that, If you enter a trade that pays you carry if nothing changes, you have an edge.

    In any case, there have been times where the Dollar helped drive some of the other markets, but at the present time it feels like the stock market is driving the Dollar. Traders are using the old carry trade thinking to come up with a best guess for where currencies should be based upon what the stock markets are doing. Maybe this is one reason why FX spec positions are not terribly large right now?

    I agree that the specs will jump back once there is good reason (a potential technical breakdown as pointed out by your charts, or perhaps some new fundamental news).

  • Posted by yoda

    california’s IOUs is worthless as california’s junk rating. IOUs at 3.5% not even fairly compensated for accepting junk IOUs.

  • Posted by yoda

    who will win? Obama’s so called high standard or Goldman Sachs get its way and push Geithner and Bernanke around? Some how I think Goldman Sachs will cook the cake and eat it. It always win. Bend over Obama.

  • Posted by Mark Dow

    D Gross – Good comments. It is great to see comments of this depth and caliber on the subject of FX.

    I think I may not have been sufficiently clear about the “risk on, risk off” effect in the dollar. I did not mean to suggest that it was the actual redemptions/subscriptions for the funds themselves, but rather the managers who run the funds/prop desks, etc. The fund flows themselves are too slow to have this kind of effect. But for managers, their ‘basis’ is overwhelmingly in dollars, so adding and subtracting risk–for whatever reason–means selling and buying dollars, respectively, and this is the main driver on a day to day basis at the margin. These flows are much bigger than commercial flows and much more frequent than reserve flows.

    One final point on the yen as a reserve currency. Market guys usually don’t get this, but policy guys do: Central banks don’t care about yield when determining their ccy mix. (I can hear traders screaming “WHAT?” across the Street right now). Central Banks care about liquidity, safety, and a mix that reflects their trade and capital flow patterns. They are sometime forced away from what would be an ideal mix for reasons like FX management, crisis response, etc. But in any event the considerations are not economic. Once the ccy mix is set, they will try to reach a little bit for returns, but within the established ccy mix and with well defined quality parameters.

    So, the main reason JPY hasn’t been a reserve ccy is not about yield; it has been because the Japanese have actively discouraged the use of JPY as an international reserve ccy. They have long viewed it as a liability as much as it is an asset. I do not think this mindset has changed in recent years. There are other, more minor reasons as well, but I thought this one was worth pointing out.

  • Posted by bsetser

    Mark — not 100% sure i agree with you Re: the yen. Sure, Japan hasn’t exactly encouraged its use in reserves, but i am not sure that they actively have discouraged it (i.e. if a country — like Russia — indicates it is buying yen, does the MoF/ BoJ send an emissary that says stop?). Central banks classically have prioritized liquidity and safety over returns (and after the crisis they returned to that). but for a period before the crisis central banks — driven by pressure to get higher returns to offset USD depreciation and by a fear that reserve management would be shifted to SWFs — were trading off liquidity and safety in a lot of ways. Within their dollar portfolio, they were buying agencies, including Agency MBS rather than treasuries, some moves into equities. And globally, they were increasing their allocation to the GBP (and I suspect the AUD and CAD) while running down their yen share. It felt like return was at the margin playing a growing role. Many central banks need a bit of cash income from the asset side of their balance sheet to avoid having to go the legislature for an approprition (a problem for CB independence). so my guess is that there is a tad more pressure for some kind of return (not necessarily a huge one) than you argued.

    incidentally, if a eur based investor buys a USD denominated fund that invests in say BRL and INR and a host of EMs that in turn sell USD for EUR to hit their reserve target, the net effect on currencies is a bit more ambiguous than if the initial inflow into a USD fund comes a USD denominated pool of savings. But i am struck by your comment and the observation that there is a larger pool of USDs in Europe (notably london) than EURs in the US, so the “return to your currency of denomination in times of risk aversion” effect is assymetric. Add in the USD funding needs of some European banks (well documented by the BIS) and you have two assymetric dollar positive flows at the peak of the crisis …

    take the Fed’s liquidity swaps out of the equation, and the USD might have appreciated by more back in sept and oct.

  • Posted by Mark Dow

    Howdy Brad. On the yen I confess I don’t know how the Japanese discourage the internationalization of the yen, but I know this has been the policy stance ever since I was aware of the subject. I probably overreached by using the word ‘actively’. There has been over the years a fair amount of literature on this subject, though the peak was when Japan was ‘waxing’ as an econ power and not ‘waning’, as could still be argued is the case today. It is true that this position could have changed in recent years, but I doubt it has.

    Also it occurs to me that the rise in recent years of buying AUD and CAD may well reflect the changing trade patterns of certain countries due to the rise in importance (and price) of commodities, and, again, the waning role of Japan in the global economy.

    All of this notwithstanding, I will concede that CBs pay more attention to yield than I implied in my post. You are right about this. The two points I was, however, trying to underscore are (1) any reach for yield is modest by market standards and comes only after the primary functions (safety, liquidity, ccy mix) are assured and reserves are above and beyond a critical mass; and, (2) in my experience traders and market guys are hard wired to think in terms of return maximization, and tend to ascribe (nearly) every CB move to the profit motive. Human nature leads us to project our utility function onto others. I find this often contributes to the information failure between policymakers and Wall Street. By now I have a fair amount of scar tissue from my attempts at this didactic process, but I soldier on…

    Lastly, on the to-ings and fro-ings of the dollar, I would add that in addition to London, I would add Geneva (and probably a host of other places like Cypress, etc, that don’t pop into mind unless I think about it for a while). And, yes, the effect is asymmetric, in a sense, but when you factor in things like leverage, the way CBs intervene, the different time horizons of the actors in your ‘flow diagram’ above, and market slippage (that 100mm can move the market 1% on certain days in one direction, but it might take 500mm to move the market 1% in the other direction), you realize that it is not anywhere close to a neat, zero-sum, closed system the way we might structure it abstractly in our heads when we thing about it. But I do see the market flows and have a very real sense of their size and reaction function, and I see first hand how risk managers are in the drivers seat of short terms moves in ccys and why the correlation between risky assets and the dollar is so negative and so strong. The flows from the goods markets and other non-speculative flows–I hear about these too–don’t come even close in terms of size and speed.

    You’re also right about the Fed’s swap lines, though one might argue that other facilities the Fed rolled out to fix the money markets and repair confidence in general were at least as effective, since risk aversion was the driver of all these phenomena. In other words, pressure on these ccys subsided whenever the S&P bounced.