Tough times ahead for US dollar

Is it safe to assume that the prospect of lower US growth and official US interest rates after the August financial crisis means a lower USD given that global growth could remain well supported, as was the case earlier in the year with the US residential market slowdown?

Non-leveraged investors are looking beyond the current financial market turbulence to buy 'assets' cheaply, based on the view that the global macro picture has not materially changed, with broad-based and solid economic growth outside the US, and consistent momentum in the emerging-market countries. This mentality has driven the rebound in equities and foreign exchange carry trades from the mid-August lows. It is certainly the case that G-7 growth was not greatly affected by the financial crises of 1987 and 1998, although this was in part due to moderate easing of monetary policy by various G-7 central banks. More recently, the world economy's ability earlier this year to weather the spillover effects from the US residential investment slowdown has also helped to add to the decoupling theory.

The macroeconomic effects of the current financial market crisis should not be underestimated, however, as the US residential investment downturn is lasting longer than expected and financial market turbulence will only constrict the supply of credit still further in the US. The financial market volatility has not ended, and central banks have not been able to restore normality to money markets. Financial institutions are unsure of the size of losses, due to the lack of price discovery in the secondary market for structured finance, while uncertainty surrounds the identities of which institutions could be carrying underwater positions. In the G-10 interbank money markets, this is prompting a heightened sensitivity to counterparty risk, which is increasing the interest rate for multi-month money and, even worse, reducing the availability of interbank funds. Banks are also now becoming reluctant to increase the size of their balance sheets, as off-balance-sheet vehicles are now being forced back on to balance sheets, due to the freeze in the asset-backed commercial paper market and the warehousing of stale structured finance deals. With certain institutions facing severe liquidity constraints, a forced firesale of assets in the coming weeks is a real risk, and could set off a vicious cycle that extends the current financial crisis. Also, the crisis of confidence in rating agencies' methodology in the structured finance market has yet to reach its peak. A fresh spike in volatility across financial markets and an unwinding of carry trades could still ensue.

While these financial deleveraging themes will be most acute in the US, the abnormal conditions in the EUR, GBP, CHF and JPY money markets show that the macroeconomic transmission mechanism cannot be restricted solely to working out how much a reduction in exports to the US means for the domestic growth picture. The supply of credit is being adversely affected in many countries and could hit the domestic macro envirnment. While all the signs suggest the Fed will cut interest rates on September 18, monetary policy tightening in most G-7 countries other than the US is likely to be delayed or cancelled. A weak USD story based on relative growth and interest rate trends alone could find difficulty building momentum. Near term, the USD is also being supported by USD buying by non-US financial institutions as a replacement for the funding normally done in the US money markets.

Yet the USD outlook is deteriorating for a number of additional reasons that are not in full focus. Firstly, the uncertainties surrounding structured finance products are unlikely to be resolved for months, which reduces an important source of USD asset demand and current account financing.

Secondly, the current financial market crisis comes as the swing towards sovereign wealth funds gathers pace, with China's $200 billion seed money starting to be put to work. From a USD-centric fixed-income portfolio, a swing will be seen towards a multi-currency asset portfolio that stretches across equities and well into emerging markets.

And in further waves of financial market liquidation, any opportunistic buying from China is likely to see less political resistance outside the US. Lastly, the US political agenda before the spring 2008 primaries could swing towards selective protectionist measures against China. While the Congressional focus is on the US subprime fallout, the interest is being driven by the base political instinct to protect growth. The growing prospect of no pick-up in the currently sub-par US growth into election year could reawaken the income inequality/protectionism/China debate in Congress, and the desire to take selective tariff action in the autumn.