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China turns to Asian bonds while Japan turns to the US. What does it mean for the dollar?

US bond prices continue to remain firm despite the recent sharp sell-off in US Treasuries by China, because Japan stepped in and bought. Where is the dollar headed? The answer will determine the trend in emerging market stocks and commodities

The yen has been strengthening against the dollar and has come all the way from 95 in early June to around 85 now. And this is not good for the Japanese economy. It leads to slower export growth, and deeper deflation. There is speculation that Japan might finally intervene to weaken its currency, something it has not done since 2004. Its strong belief that deflation will turn into inflation by 2012 seems to be unravelling. One has to also keep in mind that a weak dollar is also an issue for European exporters. However, as of now Europe is still basking in the glory of strong 2Q results and better macro economic data. An EPFR Global newsletter dated 9th August said around $789 million went into Europe Equity Funds during the week.

Meanwhile, China reduced its holdings of US Treasuries by $24 billion to $845 billion in June, this when it had already reduced it by $32.5 billion in May. It has started buying more South Korean and Japanese government bonds. That it will reduce its dependence on the US dollar is inevitable and inexorable - case in point, its recent move to add the Malaysian ringgit to a small group of currencies that it allows to be traded directly against the yuan. However, it is trying to reduce its US dollar exposure in an orderly fashion so as not to disturb the market equilibrium too much and not hurt the value of its own holdings (China is the largest holder of US debt).

So between the divergent strategies of the two giants - Japan and China - where will the US dollar go? The dollar index, while still in a negative channel, has risen from its recent low of around 80. So far, the belief that the US dollar will continue to weaken leading to a surge in commodities and equities seems to be firmly in place. Flows into EPFR Global-tracked emerging markets equity funds hit a 38-week high during the seven days ending 4th August, with Global Emerging Markets Equity Funds having their best week since late 4Q08, while Emerging Markets Bond Funds took in over $600 million for the ninth consecutive week.

However, some contrarian noises have emerged. A Morgan Stanley report early August said, "Going forward, we do not expect the US economy to decouple from the major economies. We expect the dollar to recover via either US growth rebounding in the second half of 2010 or data weakening elsewhere, or both. We forecast the US economy to grow by 3.4% and 3.3% on an annualised basis in the third and fourth quarter, higher than consensus estimates. While that is our core view, it is also possible that the US is just leading a broader decline in global activity, and if that is the case then we should soon start to see weakness in other economies, which presumably might be associated with a period of risk aversion. If we are right with either of these outcomes, we would expect the dollar to recover from its recent selloff."

It is also true that China cannot afford a collapse in the dollar as a large chunk of its savings are in the dollar, and neither can Japan afford a much more greater strengthening of its currency. This lends some support to the dollar. But for the dollar index to appreciate from here, the US needs to recover, or the rest of the world needs to be worse-off than expected - which might lead to the 'flight to safety of the dollar' phenomenon observed in the past. At the time of writing this article, the dollar index was marginally above 82.6. On the other hand, weak data from the US shows no sign of abating. Recent new US jobless claims went up to a nine-month high.

For Indian investors, especially retail, it would help to keep one thing in mind - if the dollar starts strengthening, it will not bode well for equities (especially emerging markets, due to the high beta) and commodities. Keep a sharp eye on the dollar index over the next couple of weeks.
 

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