FX Research and Strategy | G10
The dollar’s dark matter 26 April 2011
Over the last nine months the dollar has weakened significantly. The first part of Foreign Exchange Research & Strategy
the dollar weakness was driven by a shift in monetary policy expectations as the Contributing Strategists:
Fed geared up for QE2. Lately, the dollar has weakened beyond what rate
differentials would suggest. We conclude that higher oil prices as well as an under- Jens Nordvig
+1 212 667 1405
accumulation of dollars by central banks have been key factors. Meanwhile, the firstname.lastname@example.org
effect of fiscal tensions in the US is less clear. We envisage more two-way risk for
the dollar in the next 3-6 months as QE2 comes to an end and as the bull market Anish Abuwala
+1 212 667 9934
for risky assets enters a very mature phase. But conditions are not yet in place for email@example.com
a structural dollar recovery.
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Dark matter and recent USD weakness Bloomberg<NOMR>
Over the last nine months, the dollar has been on a clear weakening trend. Prior to
this period, the main source of volatility was swings in global risk sentiment, which
saw both periods of USD weakness and strength during H1 2010.
In order to analyze the drivers of the dollar weakening trend over the last nine
months, it is useful to pinpoint the part of USD weakness which can be attributed to
moves in relative monetary policy, as captured by shifts in rate differentials. Figure
1 shows a simple plot of our own broad USD index of G10 currencies along with a
similarly weighted index of interest rate differentials. As can be seen, the dollar has
broadly tracked global rate differentials since July 2010. Lately, however, the dollar
has weakened beyond what rate differentials alone would suggest.
We find it useful to decompose USD movements into moves explained by rate
differentials and a residual capturing other dollar drivers. We analyze this using a
cross-sectional regression model, which we run monthly. Figure 2 plots this ‘dollar
residual’. It shows a negative dollar residual in February and March and especially
April, when the residual was -3.2%. That is, a significant component of USD
weakness over the past several months cannot be explained by rates.
Figure 2. Monthly USD ‘residual’ moves not explained
Figure 1. Broad USD index vs. rate differentials
by changes in rate differentials
% Jan 2010 = %
2.6 100 90 8
94 4 Negative residual for
2.4 five consecutive
2.1 Rate differential (Rest of
world - US)
2.0 USD vs. selected -6
crosses (rhs inverted)
1.9 108 -8
Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11
Source: Nomura. Source: Nomura.
Nomura Securities International, Inc.
See Disclosure Appendix A1 for the Analyst Certification and Other Important Disclosures
Nomura | FX Insights April 26, 2011
Figure 3. USD ‘residual’ returns vs. oil Figure 4. Non-USD reserve buying vs. USD ‘residual’
% % 15 3mth 'residual' USD -350
10 -40 return vs. EUR
10 3mth non-USD
5 -20 Intervention (rhs -210
0 0 -70
10 0 0
-5 20 70
USD 3mth return 30 140
-10 unexplained by rate moves 40 210
Oil (3mth change) - rhs 50 280
-15 60 -15 350
Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jan-05 Jan-07 Jan-09 Jan-11
Note: USD return removes changes attributable to moves in 2yr Note: USD return removes changes attributable to moves in 2yr
rates. Source: Nomura. rates. Source: Nomura.
Dark matter, oil, reserve diversification or fiscal concerns?
Beyond monetary policy dynamics, we focus on three main potential forces which
help explain USD weakness beyond the effect from relative monetary policy
shocks (shifts in rate differentials).
Higher oil prices,
Reserve diversification by global central banks,
US fiscal concerns.
Starting with the oil effect, we have observed a clear negative correlation between
the dollar and oil prices at least since 2004. Figure 3 illustrates that there is also
co-movement between the part of dollar movement which cannot be explained by
monetary policy shifts and oil. We interpret this co-movement as linked to flow
effects—either from US energy imports or from so-called petrodollar flow. US crude
oil imports amounted to $250bn in 2010; hence a 30% increase in oil prices, as we
have observed over the last six months could trigger additional imports of $75bn
annually. Although, there are some offsetting exports, this is a meaningful impact
on net trade flows. In addition, there could be a petrodollar flow effect on capital
flow as higher income in oil producing countries (such as Russia and the Middle
East) tends to support the euro from both a trade and reserve flow perspective.
Turning to the influence of reserve diversification, Figure 4 plots our proprietary
measure of central bank accumulation of non-USD currencies along with the dollar
residual (here shown as the portion of EUR/USD moves which cannot be
explained by monetary policy shifts). Here too we see some co-movement
between the dollar residual and the pace of accumulation of non-dollar currencies
(inverted on the axis). For example, low central bank accumulation of non-dollar
currencies in late 2008 and in mid-2010 coincided with a positive dollar residual (i.e.
the dollar was stronger than rates alone would have predicted in those periods).
Moreover, the recent strong pace of non-dollar reserve accumulation (at a pace of
$200-300bn per quarter), has coincided with negative dollar residuals. There could
be causality in both directions. But if inflows into EM countries are primarily funded
in USD, central bank reserve diversification should support G10 currencies such as
EUR, AUD and CAD. In this context, we note that the pace of accumulation of non-
dollar currencies over the past two quarters has been elevated, at around 90bn per
month, although not outside of the historical range.
In relation to the impact of rising concerns about the US fiscal situation on the
dollar, the evidence is mixed. First, US CDS spreads show a spike of 7bp on the
day of the S&P announcement (Figure 5), from 42bp to 49bp. However, the spread
has not broken out of the range of the last few months. Even relative to Germany,
the US CDS spread remains within the range of the last 1-2 years.
Nomura | FX Insights April 26, 2011
Figure 5. US and German 5yr CDS Figure 6. Daily 10yr UST term premium
Jan-10 Jul-10 Jan-11 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11
Source: Bloomberg, Nomura. Note: Term premium is Kim-Wright proxy. Source: Nomura.
Second, the term premium in the 10yr Treasury bond, based here on a proxy of the
Fed’s Kim-Wright model, has shifted higher since November, but again has not
broken out of its historical range quite yet (Figure 6).
On one hand, these measures of the risk premium linked to fiscal tensions only
show mild tension, suggesting that the fiscal risk premium is not yet a major driver
of USD weakness. The price action in the Treasury market on following the S&P
outlook downgrade points in the same direction—towards still orderly conditions.
On the other hand, it is possible that the dollar could weaken due to fiscal concerns,
even if indicators of risk premia in the Treasury/CDS market are not flashing red.
This would happen in a situation where default is not in the cards, but where there
is an element of debt monetization; and the current QE2 policy does involve money
financing of government debt. It is hard to dismiss that this is playing a role in the
current dollar weakening trend, both through private sector portfolio rebalancing
effects and asset allocation decision by global central banks (more caution on USD
holdings). However, this policy has not been feeding into any outsized shift in
inflation expectations at this point. US 10yr breakeven inflation has moved up to
2.6%, up around 50bp from its level in Q4. But most of this increase has followed
the global trend. For example, eurozone break-even inflation is also up 40bp over
the same period.
Finally, it is instructive to look at recent moves compared to speculative positioning
(Figure 8). We note that Dollar shorts in the futures market are elevated, but not
higher than the levels reached in October and February, and not as extreme in
relation to open interest as back in 2007-2008. All told, recent dollar weakness has
not yet been matched by a large further accumulation of dollar shorts in the futures
Figure 7. Weekly US fund flow into foreign assets Figure 8. Net USD positioning on IMM
12 30 90
4 0 82
2 -10 80
-4 USD positioning (lhs) 74
-6 -40 72
-8 -50 70
May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11
Source: EPFR, Nomura. Source: CFTC, Nomura.
Nomura | FX Insights April 26, 2011
The dollar has been on a clear weakening trend over the last nine months. The first
part of the trend coincided with the Fed moving towards renewed easing and
initiating QE2. But the second part of the weakness from December to now has
been driven by other forces. Higher rates outside the US, especially in Europe
have played a role, but there is still a significant residual effect. That is to say,
dollar weakness cannot be explained by rate differentials alone.
In our view, higher oil prices and an under-accumulation of dollars by global central
banks are key elements in the explanation of dollar underperformance. The effect
from concerns about the US fiscal outlook is less clear; tensions in the Treasury
market have so far been mild and there is little evidence that monetization of debt
is spilling over into rising inflation expectations. Nevertheless, the flow effect from
QE2 is likely to have played a role through portfolio rebalancing effects.
Over the next 3-6 months, we expect more two-way risk for the dollar versus G10
currencies, as QE2 comes to an end and as the rally in global risk assets enters a
very mature phase, impacting global capital flows. Moreover, the effect from higher
oil prices and rising rates in Europe may soon be peaking. Hence, the risk of short-
covering dollar rallies is probably rising as we enter May-June.
Nevertheless, we don’t see the conditions yet in place for a more structural dollar
recovery. Persistent slack in the US economy and weak growth in construction is
likely to keep monetary policy accommodative for the time being. Moreover, the US
is currently on an unsustainable long-term fiscal path, and we don’t expect a
political solution in the near-term. Finally, while the dollar is getting cheap on key
valuation metrics, this has yet to feed into improved trade performance in a way
which has a decisive impact on growth.
Coming months are likely to see more two-way risk after an unusually extended
bear-run. But the conditions for a more structural dollar recovery do not appear to
be in place yet.
Nomura | FX Insights April 26, 2011
Selected recent research from G10 FX Strategy
20/04/2011 Capital Flow Monitor (Reserves): Weak USD reserve accumulation persists in Q1
15/04/2011 Strategic Currency Views: The Norwegian krone: The case for outperformance
14/04/2011 FX Insights: JPY: Update on key FX flows
13/04/2011 FX Insights: EUR: What next after 1.45?
05/04/2011 FX Insights: Eurozone Sovereign debt restructuring: Implications for bank capital and the Euro
04/04/2011 FX Insights: What we learned about the dollar in Q1
18/03/2011 FX Insights: The history of coordinated FX interventions
17/03/2011 FX Insights: Toshin flow: Outflow to slow, but repatriation is rare
03/03/2011 FX Insights: CHF: European gold?
28/02/2011 Strategic Currency Views: The UK pound: Gilt flows to assist
24/02/2011 Strategic Currency Views: The Swedish Krona - Party winding down
13/01/2011 FX Insights: The pivotal role of Spain - Part II
17/12/2010 FX Insights: What the US trade balance tells us about the USD
29/11/2010 FX Insights: EUR outlook: The pivotal role of Spain
15/11/2010 FX Insights: Measuring the risk premium on the euro
Nomura | FX Insights April 26, 2011
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