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.

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.

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.

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.

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).