The foreign exchange market has turned upside down and the dollar no longer has an anchor as investors grapple with the implications of quantitative easing, discussions to raise the debt ceiling and the recent slowdown in US growth, according to David Bloom, the global head of foreign exchange strategy at HSBC.
“The framework to think about the dollar and its link to fundamentals has undoubtedly changed. It used to be that the dollar had primacy, but now the dollar behaves like a residual currency,” said Bloom in a research note.
“Many are suggesting that fundamentals are no longer relevant but we disagree. Fundamentals are working but in a different manner. In the post-2007 environment, risk and emerging markets have become ever more important, and the way in which we look at things has significantly changed compared with the pre-crisis environment,” he said.
The difficulty for the US economy is that the recent slowdown comes at a time when a second round of quantitative easing or QE2 is coming to an end and the debt ceiling has been reached, according to Bloom who believes the end of the Federal Reserve's unconventional policy is positive for the dollar.
“The idea was that if QE2 helped fuel dollar weakness and the push into higher yielding currencies, then the end of QE2 could lead to a reversal of this process” said Bloom.
Before the crisis the dollar would trade on fundamentals like interest rate differentials, but the crisis changed that in Bloom’s opinion.
“Now, however, because major central banks have had to adopt QE or other unconventional measures, it has become harder to decipher what the impact on exchange rates should be,” said Bloom.
Dismissing the chance of America defaulting due to the failure to raise the debt ceiling, Bloom expects the politicians to agree a long-term deal at some point but warns it could be a rocky road to an agreement with a number of short-term, temporary agreements being hatched before the final agreement.
“Default by the US government would be so damaging that it seems inconceivable that Congress will allow it to happen; but it does draw attention to the serious debt issue that the US (like Europe) will have to address,” he said.
Things have changed so much that a good US jobs number can now be dollar-negative according to Bloom.
“Another way of thinking about this is to ask whether the dollar is the primary currency. Or the payrolls example: in the pre-crisis world, what mattered was the US economy and US policy,” he said.
“A stronger outcome would lead to dollar buying, and the residual to this was that if the dollar was rallying other currencies must be selling off,” he added.
“In contrast, in today’s ‘risk-on risk-off’ world, a strong payroll number is viewed as good for risk assets and therefore good for emerging markets, which leads to emerging market buying. The residual effect of this is that buying emerging market must lead to dollar selling,” said Bloom.