US dollar losing safe haven status, may spur intervention, says Nomura

“A world where the dollar cannot garner support from risk aversion is by definition a world where the dollar has lost its safe-haven status,” Nordvig argues. “And based on recent trading sessions, it appears that we are heading towards this reality.” In a strategy update published on July 27, Nordvig narrowly defines safe-haven currencies as those inversely correlated to the S&P 500, rallying when that index falls. But over the past week, the pattern has shifted, with the dollar moving in the same direction as the S&P 500 in four out of five trading days. A more normal ratio would be one in three.

A further trend Nordvig highlights is the correlation between the dollar and bond yields. The dollar is now moving negatively in sync with the US yield curve, with both declining simultaneously. Treasury yields rose above UK gilts this week, making US borrowing more expensive than UK debt for the first time in 15 months.

If the dollar is deteriorating, reserve managers’ treasury holdings are exposed to open currency risk, given them an incentive to diversify out of the dollar more quickly. Nordvig points to significant drawdowns in treasury holdings among central banks in recent months as evidence that this trend is accelerating.

Such a situation could even lead the US Federal Reserve to buy in the open market to shore up the dollar, Nordvig suggests. “From a policy perspective, it is well known that the combination of dollar weakness and treasury weakness is the one that the US Treasury fears, and one that could trigger FX intervention to stabilise markets,” he says. “We are not quite there, but the mere fact that we are heading in that direction is worth noting.”

Though the US’ structural outlook is clearly weak, one scenario that could lead to a dollar rally is a drying-up of US money markets, as in 2008. A short-term lack of dollar liquidity was exacerbated as lenders resorted to dollar hoarding. This forced the Fed to pump in liquidity, extending dollar swap lines to those struggling to obtain credit.

Such a scenario is less likely to occur this time, as overnight credit markets have remained largely unperturbed by recent stress. Dollar holdings are also more plentiful among European central banks than they were in 2008, Nordvig notes. All of this makes it more likely that a US downgrade will lead to structural dollar selling, he argues, particularly the closing of crossborder transactions where the US dollar is used as a funding currency.

The fundamental problem remains the lack of a global alternative to the dollar as a reserve currency, Nordvig concludes, given the significant near-term problems facing the euro. Specifically, he argues that the European Financial Stability Facility will be unable to cope with the contagion effects of an Italian, or even a Spanish, debt rollover.

Currencies that have so far outperformed during the protracted US debt ceiling negotiations are the Australian and Canadian dollars and the Swiss franc. Nomura expresses some surprise that the Swedish krona has not benefited from stronger haven flows, given its triple-A rating. It notes that the krona finally started to outperform on Tuesday (July 26), adding that it expects this to continue over the medium term.

The diversification trend towards emerging-market central banks holding reserves in currencies other than USD, EUR, CHF, JPY and GBP, which grew from less that 2% to more than 6% (to around $150 billion) over the past two years, also looks set to accelerate, Nomura suggests.

Searching for smaller pockets of safety among G10s and selected EM currencies looks set to be the dominant trend over the next year, Nordvig concludes.