Asset flow tug-of-war to buoy dollar until Q1 '09

LONDON (Reuters) - The dollar is expected to remain buoyant into early next year in a global tug-of-war between investors repatriating trillions of dollars of foreign assets and the attraction of U.S. government paper as a safe haven.

While many analysts are increasingly wary of what happens to the dollar once a stress-driven preference for U.S. Treasury debt, deleveraging and capital preservation subsides, most agree the process has further to run.

This essentially "forced" flow of money has meant the fate of the dollar has become closely linked to the intensity of the financial storm. Take a punt on the timing of the crisis peak and you will also probably bet on the dollar cresting.

With the Federal Reserve adopting an aggressive policy of quantitative monetary easing measures -- printing money in effect -- the dollar outlook for later in 2009 looks darker.

But as long as the financial world remains in turmoil, there's potential for billions of dollars to be channeled back into U.S. cash as the scramble for dollars from both U.S. and overseas investors continues, albeit at a slower pace.

An analysis by Swiss bank UBS shows that the proportion of foreign assets held in the portfolios of U.S. mutual funds fell to 22.5 percent at the end of October from a peak of 26 percent a few months earlier.

"Repatriation has also been evident (in) the share of foreign assets falling faster than can be accounted for by exchange rate or global market changes. If investors remain risk-averse in coming months as we expect, the scope for further repatriation and therefore dollar support still remains significant," said Mansoor Mohi-uddin, head of FX strategy at UBS in Zurich.

Mutual funds' foreign market holdings in the last decade bottomed at around 13 percent of their portfolios in early 1999 and in mid-2002, UBS charts show.

The total value of U.S. mutual funds is thought to exceed $6 trillion.

Michael Hart, head of FX strategy for Europe at Citigroup in London, estimated that U.S. investors put around $1 trillion into foreign assets over the past three years, suggesting there's more leeway to bring money home.

"We're in a tug-of-war between U.S. risk-averse investors repatriating capital and foreign risk-averse investors shedding U.S. assets. It seems to me that U.S. flows could (still) outweigh foreigners'" repatriation flows, Hart said.

EURO AT $1.15?

The dollar surged around 17 percent against a basket of six major currencies .DXY between the end of July and last week.

The bulk of that rally came after the collapse of Lehman Brothers in early September triggered a critical phase in the global financial downturn and a worldwide scramble for dollars to cover exposure to U.S. assets, meet dollar funding requirements or U.S. repatriation.

The latest official figures from the U.S. Treasury show that foreign investors plowed a whopping $143.4 billion into U.S. securities in September, the largest in nearly three years and easily enough to cover that month's $56.47 billion trade gap.

But that flow was prompted by investors panicked into huge position unwinding by fears the financial system was close to meltdown, and massive selling of emerging market assets for relatively safe dollar-based investments.

Financial markets aren't expected to function anything like normal any time soon as the intended effect of the multitude of financial market programs and operations from global central banks will take time to emerge.

"A few more months of risk-reduction lies ahead, which should strengthen both the dollar and the yen," said Steve Barrow, senior currency strategist at Standard Bank, adding that the next few months will be less volatile than the last few.

He says the euro could fall to as low as $1.15 from current levels around $1.30 and sterling to $1.40 from around $1.55.

BEYOND THE HUMP

In this environment, the "forced" flow back into dollars will remain positive but possibly at a slower pace.

"The forced dollar buying was dollar-supportive but once that pressure has gone, we don't see much evidence for genuine demand for U.S. assets," said Thomas Stolper, currency strategist at Goldman Sachs in London.

He noted that the September Treasury flows data showed net U.S. inflows into longer-term securities like bonds, notes and equities eased significantly to $30.9 billion.

Of that, net purchases of Treasuries totaled $20.7 billion, down from $34 billion in the two previous months.

"The problem is the trade deficit remains relatively wide on the back of slowing external demand, so the U.S. still has to attract the funding flow in order to avoid structural dollar weakness," he said.

Stephen Jen, head of global FX strategy at Morgan Stanley, shared Goldman's bullish view on the dollar earlier this year. He still expects the dollar to strengthen over the next six months as global disinflationary pressures and economic weakness extends the global flow back into the greenback.

But the consequences of the Fed expanding its balance sheet by hundreds of billions of dollars will eventually take its toll on the U.S. currency.

"The underlying factors that have forced the Fed to conduct quantitative easing are likely to be dollar-negative," he said in a note this week.

"Based on our fair value framework, we expect the fair value of the major dollar index to decline by 5-7 percent."