Abheek Barua & Bidisha Ganguly: The curious case of the waning dollar

To an extent, the anti-dollar trade seems to be a reaction to the period over which the dollar rallied against other currencies. It gained strength with the emergence of the US as the only developed economy showing signs of recovery

A strange thing is happening in the world of international currencies, something that flies in the face of textbook economic theory. Major economies that have pumped cash into their economies, effectively bringing their interest rates down, have seen their currencies appreciate against the US dollar. This, despite the fact that the US central bank has stopped infusing liquidity, has actually hiked its policy rate and is likely to hike some more if the economy posts more good news and data. The interest rate difference works in favour of the US and conventional economic theory would predict that nimble global investors would borrow in the low-interest currency and park their money in dollars, causing the dollar to appreciate. But this simple logic of arbitrage has broken down.

Take the yen for instance. The Bank of Japan has a hefty cash infusion scheme, a benchmark policy rate that is zero and since February has tried to push interest rates down further by offering negative return on excess balances that banks want to park with it. Economics 101 would be unequivocal about the fact that the Japanese currency should take a hit against the dollar. Yet the currency has appreciated by 4.5 per cent since the beginning of January against the dollar and might gain some more.

Ditto for the euro that's gained by nine per cent over this period. This came after the European Central Bank increased the size of its quantitative easing programme by Euro 20 billion, cut its (already negative) rates on excess balances further and introduced the refinance programme for banks (targeted longer-term refinancing operations) with funding rates as low as minus 0.4 per cent.

To understand this somewhat bizarre pattern of behaviour for these currencies, it is important to get a handle on what's been happening to the US dollar. The appreciation of the yen and the euro is part of a much bigger picture where virtually all currencies have appreciated in what one could call a massive anti-dollar trade. All currencies, particularly the ones linked to commodity economies like Brazil, have rallied against the US currency against what one could call a massive anti-greenback move. But why?

The negative sentiment towards the dollar essentially reflects the US Federal Reserve's earlier decision to push back on interest rate hikes and moderate the market's expectations. While the Fed had earlier led the market to expect four rate hikes in 2016, it later retracted, pointing to the still weak performance of the economy. This sent the dollar tumbling against a range of currencies, with the trade weighted dollar index falling by about five per cent since its January peak.

The anti-dollar trade also seems to be a reaction to the long period over which the dollar has rallied against other currencies, gaining strength with the emergence of the US as the only developed economy showing signs of recovery. Ironically, a strong currency may have hurt the US economy, making its goods and services less competitive in the global market.

Then there is the curious business of the "risk-off". Japanese investors are usually great risk-takers and seek higher returns outside Japan. But they seem to have panicked suddenly and brought their money home, putting upward pressure on the yen.

This leaves the Japanese central bank in a difficult position. Deflation has been a major concern for the Japanese economy and a strong currency would make this worse, further lowering the price of imports. Japan has in the past been known to "intervene" in the currency market, initially, verbally and then through actual purchases or sales of the yen in the markets. Thus it must have been difficult for Bank of Japan Governor Haruhiko Kuroda to stand by to honour its commitment to the G-20 to avoid competitive currency interventions.

The same story holds for the euro. A depreciated currency had raised hopes of a recovery in the region at the beginning of this year, but a stronger euro for the last month and a half might just dash those hopes. Oh, what a tangled web we weave.
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is principal economist, CII