The new 'growth' currency

The inverse relation between dollar movements and risk soon change

A new trading theme is emerging in the financial markets that could determine the way currencies move against the US dollar over the coming quarters, or perhaps even years. The dollar is making a transition from being what is known in the jargon as a "funding" currency, to what's called a "growth" currency in trader-speak.

Over the last few years, dollar movements correlated inversely with risk appetite. There were essentially two reasons. First, the dollar was the "safe haven". When investors turned anxious, they sought the safety of the good old greenback. It didn't often matter that the reason for the anxiety was quite often the US economy itself. Enhanced risk meant a bid for the dollar.

What happened when there was less anxiety around? We now turn to the second reason for the inverse correlation of the dollar with risk. When risk appetite increased, investors decided to chase yields that were often to be found in assets outside the US, say, in European bonds or emerging market stocks. How did they fund these purchases? They didn't have to look far, since there was the US Federal Reserve offering lots of dollars (it still pumps in $85 billion into the monetary system though the quantitative easing or QE programme) at ridiculously low interest rates. In short, the dollar funded purchases of these risky assets (the so-called "carry-trade") and was, thus, a "funding currency". The upshot was that as risk appetite increased, the dollar found itself depreciating, since investors borrowed dollars and bought euros, rupees, and so on. Conversely, when there was more risk in the air, the dollar appreciated.

The transition in the status of the dollar from "funding" to "growth" in effect means that this inverse correlation is breaking down. This shift can be interpreted in different ways, but they all hinge on the fact that the markets are growing increasingly sanguine that the US is now quite decisively on a recovery track.

Here's how I interpret it. As growth picks up, the chance of the US central bank stepping back from its "super-easy" monetary policy will increase. There are already rumblings within the high-powered Federal Open Market Committee about the costs of continuing with QE. These include the risk of a rise in inflation at the first sign of growth and issues related to financial stability (cheap dollars are apparently being sucked up by a raft of dodgy bonds). There is also the business of "rotation" where money is leaving the US debt markets and getting into equities. The result is a rise in bond yields and the cost of borrowing.

The implications are the following: going forward, dollars might not come that cheap anymore. In fact, the better the data, the quicker the rise in the cost of money. This will slowly put an end to the money-for-jam carry-trade. On the other hand, as the US growth situation improves, both the US bond and equity markets will start looking attractive. Thus, money from outside the US will chase American growth and yields, instead of dollars funding yield-chase outside. This is likely to mean dollar-strength.

How does improving expectations of the US growth square up with the fiscal impasse that it is going through? Investors don't doubt the fact that things like sequestration or higher payroll taxes will affect the level of growth, but they also don't doubt that the economy is headed in the right direction. Bellwether sectors like auto and housing have picked up, and some recent prints from the labour market also seem encouraging. Thus, while the government is playing a party-pooper, the private sector is picking up.

There are some who buy the argument that the US economy, particularly its manufacturing sector, is going through positive structural changes that would, with time, place it on a new and sustainable growth path. The extraction of larger and larger volumes of shale gas has already driven a sustained downward shift in its trade deficit. Thus, the massive trade imbalances (and spillover to other macro imbalances) might just be a thing of the past. Cheap shale gas used either as fuel or feedstock has substantially reduced the cost of manufacturing for a number of sectors, and bred a new competitiveness. Labour productivity has also risen over the past few years and will help to sharpen the edge of manufacturing.

I would argue that if these emerging trends for the US sustain, the dollar might see a sustained bull run. That would prima facie mean depreciation for the rupee going forward. There could be, however, differences in the degree to which the dollar rises against different currencies. It could, for instance, appreciate more against free-floating currencies like the euro or the pound. On the other hand, if the India story revives and the current account imbalance corrects a little, the rupee might not depreciate much. That said, I would make a case for depreciation on average in the medium to long term. I am not claiming that this is will be a linear process. There could be the odd year when the rupee actually appreciates against the dollar. However, it might be prudent to factor in a two to three per cent average depreciation of the rupee against the dollar.

The author is with HDFC Bank. These views are personal