Wednesday, November 18, 2009

Goldman Sachs On Dollar Weakness

Goldman Sachs attempts to explain (and does a pretty damn good job of it) dollar weakness that is not the result of carry trade activity:

While there has been a pick-up in investment in higher yielding currencies and assets, there is a distinction to be made between speculative carry trades and investments made on the basis of stronger EM fundamentals. It is hard to draw the line where investment activity becomes a speculative bubble but we do not think that we are in the midst of a 'carry bubble' at the moment. Yes, inflows into EM assets have accelerated rapidly over the last several months but this has also arguably been led by improving fundamentals in these countries in general. US equity fund flows into EM markets have broadly tracked the widening growth gap between EM countries and the US. We use a simple measure of real GDP growth in EM countries minus US growth to track the latter, which shows that the EM-US growth differential had peaked in 3Q of 2008, bottomed in 1Q 2009 and has since widened out again over the last 2 quarters . Plotting this EM-US GDP differential versus US equity fund inflows into EMs, there does not seem to be any significant divergence. The point being that EM equity flows so far have been underpinned to a certain extent by relatively stronger recovery prospects.

Other factors underpinning Dollar weakness include hedging asymmetries. We have most recently discussed this in our latest November FX monthly publication. In a nutshell, this refers to the likelihood that overseas investors in US assets appear to be FX hedged to a greater degree than US investors of foreign assets. As a result, a rally in risky assets tends to result in Dollar selling to maintain hedge ratios.

Finally, part of the Dollar weakness trend observed so far since the crisis has also been due to the ongoing normalization in markets. This has been well described in a recent speech by Chairman Bernanke: ‘When financial stresses were most pronounced, a flight to the deepest and most liquid capital markets resulted in a marked increase in the dollar. More recently, as financial market functioning has improved and global economic activity has stabilized, these safe haven flows have abated, and the dollar has accordingly retraced its gains.’ Indeed, our GS USD broad TWI has retraced to a large extent but even now is still slightly stronger than the levels of autumn last year.
The one I find most fascinating is the asymetric hedging, which explains the close relationship between down movements in the dollar and up moves in the stock market (and up moves in the dollar with down moves in the stock market). According to GS, international investors in US assets are hedging their dollar exposure, which means as the stock market goes up they are hedging by shorting more dollars. Of course, if the stock market breaks, as I expect it to, the dollar will experience aggressive buying by those removing their dollar hedge.

Goldman continues
Thus while there are Dollar-funded carry trades and certainly other cyclical factors behind the Dollar’s weakness, we do not think we are seeing a speculative ‘carry bubble’ for now. The difference being a 20% strengthening in the Dollar upon a reversal, over say 3 months as opposed to 3 days for the latter.
This is where I depart from Goldman, a downturn in the stock market could be very pronounced and rapid. The reversal of the carry trade might not cause it, but certainly a reversal in the stock market could see a very dramatic phase that won't require three months to play out. A dramatic reversal in the stock market will cause a reversal in those short-dollar hedge positions.


  1. Sorry but I have to ask (even if it shows my ignorance): What does EM stand for?

  2. Good question. I should have clarified.

    EM = Emerging Markets, which is broadly defined and includes, China, Eastern Europe, Africa etc.