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Implications of the Treasury's Plan for the Dollar

Mon, Sep 22 2008, 15:44 GMT
by Jay Bryson

Wachovia

Treasury’s plan represents a short-term negative for the dollar.

In our view, this weekend’s announcement that the U.S. government will buy up to $700 billion worth of bad debt from financial institutions is a short-term negative for the dollar. In order for investors to absorb the increased issuance of U.S. Treasury securities the returns on those securities will need to rise. From the perspective of a foreign investor there are two ways that returns can rise. First, the yields on the securities need to increase. Because the proposed program is equivalent to nearly 15 percent of the marketable Treasury debt outstanding, a rise in Treasury yields seems to be in the offing. The second way that returns to foreign investors can occur is via depreciation of the dollar. In theoretical terms, this is known as “overshooting.” That is, the dollar depreciates a significant amount initially. A foreign investor who buys Treasury securities when the dollar weakens can realize a significant return if the greenback subsequently appreciates.

How does overshooting work in practice?

Foreign investors initially shun U.S. securities, waiting for their yields to rise to more acceptable levels. Because the United States is running a large current account deficit (nearly $700 billion over the last four quarters), reduced inflows of foreign capital are not large enough to finance it. Consequently, the greenback weakens. Once nominal yields rise “far enough” and the dollar depreciates “far enough”, foreign investors become attracted to potentially outsized returns on U.S. Treasury securities. As foreign investors start to buy these securities, U.S. capital inflows strengthen and the dollar then begins to appreciate.

What happens to the dollar in the near term?

In our view, the greenback is most exposed to European currencies. Treasury’s plan should reduce financial risk, at least in the near term. Because investors pile into the Japanese yen when risk aversion spikes, we are ambivalent about the near-term direction of the yen/dollar exchange rate. Therefore, we believe dollar weakness will manifest itself via European currencies. In terms of the euro, we would look for a near-term test of the 1.47 area. If resistance there breaks, a run-up to the 1.53 area seems likely. In a worst case scenario, a retest of the all-time highs of 1.60 could be in play (see Exhibit 1). In our view, dollar depreciation will play out over the next quarter or two as prospects for U.S. economic growth remain clouded.

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Published on  Tue, Sep 23 2008, 14:10 GMT