Dollar to benefit from end of diversification

Mansoor Mohi-uddin, head of FX strategy at UBS, says the dollar’s weakness during the past decade was due to the three largest holders of dollars globally – US fund managers, foreign central banks and sovereign wealth funds –shifting away from US markets. But he believes the US currency is set to appreciate as the US capital account benefits as dollar-based investors slow foreign-assets purchases.

“Dollar-based investors remaining in US markets would be highly beneficial for the greenback,” says Mohi-uddin.

“It would also result in a regime shift so that the currency rises rather than falls when investors seek risk, just as it did in the 1990s.”

Signs that dollar diversification is coming to an end have emerged as the US starts to outperform other advanced economies.

Mohi-uddin says this matters since the sheer size of fund managers’ portfolios means that shifts towards foreign markets can lead to capital flows dominating trade flows.

Indeed, the US annual current account deficit is less than $500 billion, but UBS estimates the private sector globally manages US$100 trillion of liquid financial assets, central banks have $10 trillion of foreign reserves and sovereign wealth funds $3 trillion.

The US has the world’s largest fund management industry, with around $40 trillion of assets.

The latest data from the Federal Reserve shows that the eurozone debt crisis, fears about the global economic outlook and America’s economy starting to outperform its peers in Europe and Japan are checking US fund managers’ dollar diversification.

This is a major shift, given that there has been a strong trend by US mutual funds to hold more foreign assets after the collapse of the internet bubble in 2000. “US equity markets when adjusted for exchange rates are now outperforming foreign markets just as they did in the late 1990s,” says Mohi-uddin. “That could lead to US fund managers reversing their decade-long dollar diversification, and begin repatriating capital back home instead.”

Meanwhile, central bank reserve managers and sovereign wealth funds also appear to be reducing or even reversing the trend of dollar diversification they have largely followed for the past decade.

For official investors, the crisis in the eurozone has reduced the euro’s appeal as a reserve currency, with the figures from the International Monetary Fund showing the proportion of foreign exchange reserves held globally in dollars rising back above 61%.

Mohi-uddin says the end of dollar diversification could result in a regime shift in the currency markets.

During the past decade, dollar diversifying investors have weighed on the dollar by seeking risk in higher-yielding foreign assets, making the US currency negatively correlated with measures of investor sentiment.

“But if investors now start to favour US markets more again, the dollar may behave as it did in the 1990s when it strengthened on the back of capital inflows as equity markets rose rather than falling on the back of increased dollar diversification,” says Mohi-uddin.