Hedging activity could add to dollar pressure
By Christopher Swann
Published: January 14 2003 4:00 | Last Updated: January 14 2003 4:00
Recently even the dollar's most loyal friends have been deserting it.
ABN Amro, which has been sceptical of the euro's ability to rise against the dollar, is now taking a more downbeat view of the dollar's prospects.
Its bearishness is not based on expectations of large sales by international investors, but rather on the growing temptation to hedge dollar risk by selling the greenback forward.
The incentive to hedge against a further fall in the dollar has become quite compelling. The euro value of the S&P 500 fell by 35 per cent in 2002 - compared to a fall in its dollar value of 23.4 per cent.
Many fund managers are now fretting that this currency loss may be repeated in 2003. The cost of hedging the dollar is cheaper than in many years.
This is due to the fact that US interest rates are below eurozone rates creates and are now much closer to rates in Japan and Switzerland.
Investors tend to hedge by buying dollars in the spot market - in order to buy the assets - and then selling dollars in the forward market. Since the forward price of the euro-dollar, for example, is calculated by taking the spot price and adding in the interest rate differential, the dollar forward is higher than the spot price.
"For a eurozone investor, it now pays to hedge your dollar exposure and it is pretty cheap to hedge if you are in Switzerland or Japan too," said Tony Norfield, head of currency strategy at ABN Amro in London.
Six-month interest rates in the US are now around 1.4 per cent, compared to 2.75 per cent in the eurozone and close to 4 per cent in the UK.
Mr Norfield estimates that portfolio managers may increase their hedging ratios by as much as 15 percentage points by the middle of the year.
If this forecast proves true it would have serious implications for the dollar. The US has become increasingly dependent on portfolio flows to fund the current account deficit - a net direct investment inflow of $3bn in 2001 became a $66bn outflow in 2002.
At the end of last year US foreign investors held $1,200bn in US Treasuries, $1,700bn in US corporate and agency bonds and $1,100bn in US equities.
Tony Norfield said that although a significant portion of these assets were held by central banks that were unlikely to hedge, a 15 percentage point rise in hedge ratios would imply around $270bn of dollar selling from European investors alone.
ABN Amro is now forecasting a rise in the euro to $1.09 within the next few months.
But not all strategists were so bearish about the short-term outlook for the dollar. Michael Woolfolk, head of currency strategy at Bank of New York, said that the bank's portfolio flows indicated a shift away from the eurozone into the US at the end of last week. The IMM data from the Chicago Mercantile Exchange also pointed to a reduction in long euro-dollar positions.
"Positions against the dollar have become over-extended and there is a chance of a swift pull-back," he said. "The retail sales figures this week should underline the resilience of the US consumer," he said. The pull-back, he predicted, could take the euro back to $1.025 this week.
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