June 25, 2009 / 7:50 PM / in 10 years

Liquidity crunch to keep U.S. dollar demand strong

NEW YORK (Reuters) - Currency investors betting on a weaker U.S. dollar in the second half of the year, following steep declines in the past two months, may be getting ahead of themselves.

While nascent signs of global economic improvement have bolstered non-dollar assets of late, persistent credit tightness in the market — despite massive capital injections from the Federal Reserve — should ensure dollar demand will remain intact at least in the next six months, analysts say.

“The enthusiasm of the past three months has led many to believe that the Fed has actually provided more than adequate liquidity,” said John Taylor, chairman of FX Concepts, a $12 billion hedge fund in New York.

Investors have viewed rising stock markets worldwide and a falling dollar as evidence that a global rebound was underway. But Taylor said the underlying financial asset contraction tells a different story.

“It is critically important to remember that the dollar is the funding currency whose availability, or lack of ... will drive all the markets in the world,” he added.

ANYBODY HAVE A DOLLAR?

In May, the ICE Futures’ dollar index .DXY, a gauge of the greenback’s value against a currency basket, fell 6.6 percent. The index is down 0.9 percent so far this year after rising about 6.0 percent in 2008.

The dollar’s decline coincided with what many perceive as indications that the recession has started to ease. Investors therefore saw less need to hold the dollar as a safe haven.

But the shortage of dollars is critical for the forex market, and should continue to support the greenback in the second half of the year.

Although the Fed has expanded its balance sheet dramatically and several other major central banks have done the same, currency reserves have declined.

The latest International Monetary Fund data showed that currency reserves, the bulk of which are held in U.S. dollars, has declined at the end of the fourth quarter last year to $6.7 trillion from a peak of more than $7 trillion at the end of the second. This was the second straight quarterly decline.

Strategists said a decline in reserves reduces liquidity, and this is historically negative for growth and equities. But they act as a positive for the dollar given there is less high-powered money in the global system.

While the IMF numbers are dated, analysts said the declining trend in reserves for the first half of the year may still be in place because of weak revenues from exports. In addition, some central banks have dipped into this pool of funds to help support their economies fight the crisis.

FED INJECTIONS FAIL TO SPUR LENDING

U.S. bank assets have fallen much more this year. More importantly, cash infusions into banks from the Fed have yet to stimulate consumer and small business lending, U.S. data show.

For instance, short-term credit provided to finance mortgages, auto loans, and other businesses fell at an annual rate of $662 billion in the first quarter, according to the Fed’s quarterly report on fund flows.

“The Fed’s numbers demonstrate beyond a shadow of a doubt that the credit market meltdown ... got a lot worse in the first quarter this year,” said Martin Weiss, president of Weiss Research in a research note.

Analysts said for things to get better, banks must start lending again. Financial institutions, worried about borrowers’ creditworthiness and an economy in recession, have become extra cautious in extending new loans.

As a result, banks are shrinking — new loans are hard to get, credit cards are being cut and rates are climbing.

“To see a sustainable recovery, you need to see bank balance sheets keep on growing,” said Richard Franulovich, currency strategist at Westpac in New York. “The fact is they’re stalling and that could be a pre-condition of risk aversion down the road.”

He added that markets may have been overzealous in pricing a dollar downtrend now that currencies and risky assets are trading at levels before the collapse of Lehman Brothers.

“But multi-week, there’s could be probably a pullback in risk assets and a rebound in the dollar,” Franulovich said.

Many believe the dollar is facing a headwind in the long term because of the record U.S. fiscal deficit and the prospect of low interest rates for an extended period of time.

For now, until markets normalize and the recession fades, liquidity rules, and the dollar is king. “It does not matter one whit that Russia and China trade with each other in renminbis, roubles, or plastic dolls, global liquidity is denominated in dollars whether we like it or not,” said FX Concepts’ Taylor.

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