Resurgent Dollar Leaves Gold in the Dust...

The unloved Dollar has proven among the best performing assets over the past 12 months as the dollar index gained 26%, with 'safe haven' gold pretty much flat, having peaked 10% above current levels last April. The irony is that just about every goldbug was also a convinced dollar bear a year ago, and their emotionally charged analysis has proved utterly misconceived in a deleveraging global economy. On July 27th last year, I wrote: 'The Euro, Yen and Sterling all risk major fundamental downside over coming months as evidence mounts that their respective economies are sliding into recession; decoupling is dead. Meanwhile the US trade deficit is in rapid decline... the prospects of a sharp dollar rally in the next few months are high.' Currency analysis isn't that complicated; ultimately, it comes down to whether foreign demand for US assets exceeds US demand for foreign ones. Not only did it seen obvious that the world economy would 'recouple', but also that a bursting commodity bubble would prove dollar positive.

But beyond these supportive factors, it became clear in the Autumn market panic that the world was structurally short of dollars, from professional speculators to emerging market corporates and foreign commercial banks. Indeed, the huge natural short position built up in European bank loan books is detailed in a new BIS report available here. Many observers forgot that the low-yielding dollar was a 'carry trade' funding currency for foreign investors almost as much as was the Yen in the boom years. Another factor was the fact that Americans were selling foreign financial assets faster than foreigners were selling American ones through 2008, as can be seen in the chart below. Additionally, there was a huge surge in safe haven buying of T-Bills in late 2008 by overseas investors. So where to now for the newly virile dollar? While capital flows globally are still contracting, the way in which they are doing so is still proving dollar positive. I think the impact of rising US savings (to maybe 8-10% by year-end) and its impact on funding both the trade and fiscal deficits, is key to the outlook.

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