Foreign Central Bank Intervention Could Prolong Dollar Rally
I still think it is overvalued in the sense that in the absence of central bank interventions, it would drop sharply. But I now think it might stay overvalued for longer than I previously thought.
Essentially, exchange rates like all other prices are determined by supply and demand. For currencies, this supply and demand can be further sub-divided into supply and demand for goods & services and supply and demand for assets. Demand for a certain currency is constituted by foreigner's purchase of domestic goods, services and assets, while supply of a certain currency is constituted by domestic demand for foreign goods, services and assets. If a certain country (or more strictly currency zone) runs a trade deficit, this means that domestic demand for foreign goods & services is greater than foreign demand for domestic goods & services, or in other words that the goods markets create a net demand for the foreign currency. In order for currency markets to remain in equilibrium, this requires a net demand for the domestic currency in the asset markets, or in other words that there is greater foreign demand for domestic assets than domestic demand for foreign assets.
Moving from this abstract general theoretical reasoning to the specific case for the U.S. dollar, it is clear that in the absence of central bank intervention, the dollar should and would fall. The U.S. runs a still large trade- and current account deficit, meaning that there is a large net demand for foreign currencies in the goods markets. At the same time, the U.S. provides worse value for investors than just about any other countries. While U.S. stocks may no longer thanks to the recent sell-off be overvalued in a historical sense, they are still overvalued compared to stocks. Meanwhile , interest rates on government securities are lower than in almost all other countries (particularly after adjusting for inflation) while the so-called sophisticated debt securities (including mortgage backed securities) issued by U.S. investment firms have turned out to be hoaxes backed by dubious collateral, and so should impress no one at this point. There should therefore be no reason why the U.S. should attract foreign capital more than foreign countries should attract U.S. capital. This should create a strong disequilibrium in the sense of shortage of demand for U.S. dollars, and so should drive down the value of the U.S. dollar so as to reduce, if not eliminate, the trade deficit and also make U.S. assets cheaper.
However, the problem with the above analysis is that it only applies to currency markets where central banks or other government institutions don't intervene. In reality they do, as we all know. Central banks have of course been net buyers of U.S. assets for years now, but until recent months these purchases where relatively moderate and more diversified into other mayor currencies such as the euro. Now, in recent months, central banks purchases of dollar assets as shown in Fed statistics have soared. From having financed less than half of the trade deficit, it now finances more than 100% of it. This implies that the required non-central bank capital inflow has gone from nearly $30 billion per month to being negative, causing the dollar to soar.
Returning to the theoretical level, this means that you can't analyze merely in terms of how attractive these assets are with respect to for example interest rates. You also need to take central bank behavior into account.
The real question in this supply & demand analysis is how central banks will behave in the future. If they stop or greatly reduce their dollar purchases, then this will doom the dollar rally. If they keep this up, however, the dollar rally will probably continue, or at the very least it won't be reversed.
Of course, we can't know for sure how they will behave. But there are increasing signs that they won't reduce their dollar purchases anytime soon. Because of the global downturn, many Asian countries that once tried to restrict their dollar purchase to limt the growth of central bank balance sheets and so contain inflation have now indicated that they will step up dollar purchases to hold down the exchange rate of their currencies to subsidize exports. The up tick in dollar purchases and the ensuing dollar rally came very soon after China stopped the gradual yuan appreciation in early July, indicating a great role for China in these events. And as the Chinese leaders seem increasingly worried about growth, and less and less worried about inflation, there is no reason to believe they will scale back dollar purchases.
Another indication was the announcement by Singapore this week that it would end the gradual currency appreciation policy to boost growth. And it seems likely that many other countries in Asia and elsewhere will reason as China and Singapore.
For that reason, it seems likely that central banks will keep up the high pace of dollar purchases as long as growth remains weak, which will probably be until at least next year, prolonging the dollar rally. Meanwhile, the trade deficit boosting effect of the dollar rally will be limited by the decline in the price of oil. The most uncertain factor here is private sector capital flows, which pose the great threat to the dollar rally, given the aforementioned low value provided by U.S. assets. The likely imminent temporary stock market rally could again increase the willingness to invest outside the U.S., and so push down the dollar against other currencies (except the yen, which will probably fall if stock markets rise) during the coming rally. This effect will however be limited by the central bank actions, and once the rally is over, this effect will disappear.
The bottom line is that the increased central bank purchases will probably continue and this will likely prolong the dollar rally until they decide to reduce these purchases, which will probably not be until the economic slowdown/downturn ends.