Sliding Dollar Could Hit U.S. Fixed Income

greenspun.com : LUSENET : Grassroots Information Coordination Center (GICC) : One Thread

Sunday September 2 8:23 AM ET

Sliding Dollar Could Hit U.S. Fixed Income

By Eric Burroughs

NEW YORK (Reuters) - The dollar's recent slide on fading hopes of a quick U.S. economic rebound may be the catalyst for global investors to yank money out of U.S. fixed income markets, further undermining the once-mighty greenback.

Foreigners have pumped almost $500 billion into U.S. credit markets in the past three years, according to Wall Street investment bank Merrill Lynch. The flows kept pouring in this year, as an appreciating dollar boosted returns despite the Federal Reserve (news - web sites)'s slashing of interest rates.

Meanwhile, during the first half of the year, returns for U.S. investors in Europe shriveled as the euro weakened. European fixed-income returns underperformed the United States for local investors even though the European Central Bank (ECB) cut interest rates just once compared with seven cuts by the Federal Reserve.

Normally, when a country's interest rates fall, its currency follows them down as investors seek higher returns elsewhere.

But until recently, the dollar was resilient despite sharp rate cuts because investors expected a quick U.S. economic turnaround and still saw those assets as attractive relative to the alternatives.

Things may be changing now. The euro has risen almost 10 percent against the dollar since early July. With inflation worries receding, the ECB is expected to cut rates this week.

Investors see the potential for European markets to outperform even if rates are cut more deeply because short-term European rates are still a full percentage point above those in the United States.

``The U.S. dollar has been and still is tremendously overpriced. To the degree that people give up on this quick recovery, that's a negative for the dollar,'' said Peter McTeague, fixed-income strategist at Greenwich Capital Markets.

``Over time, the dollar will come down and people will send their money to higher returning markets,'' McTeague said.

WEAKER DOLLAR, COSTLIER DEBT

The dollar could also come under pressure as Japanese investors sell U.S. holdings to repatriate funds to cover stock losses back in Japan.

Analysts said foreign investors mainly own Treasuries and spread product, such as agency and mortgage-backed securities, in short-dated maturities, and those issues are the most likely to see sharp spread widening if foreigners sell U.S. fixed-income assets.

``Should foreign demand begin to withdraw, we would expect that agency and corporate spreads begin to widen,'' said Thomas Sowanick, chief global fixed-income strategist at Merrill Lynch.

Sowanick said agency securities have benefited the most from the decline in Treasury supply, and the threat of a weakening dollar could lead investors to ``quickly exit'' agencies.

A weakening dollar could revive inflation worries and drive up yields on longer-dated Treasuries, although some analysts said such a scenario was less likely with inflationary pressures in fast retreat as global demand slumps.

Foreign liquidation of U.S. assets would drive up the costs of corporate debt, limiting the ability of U.S. companies to raise new funds for investment or growth. That would stymie the Fed's aggressive credit easing this year to boost demand and help businesses escape from a steep decline in profits, which has led to the sharpest drop in capital spending since the early 1980s.

So far this year, U.S. and foreign investors have had little reason to invest in Europe and every reason to keep their money in the United States.

The Lehman Brothers Global Bond Index shows dollar returns in Treasuries have risen 4.5 percent this year. For European investors, the 3.0 percent appreciation in the dollar against the euro would have brought returns to more than 7.5 percent.

Investing in Europe has proved less rosy. European debt has returned only about 3.3 percent, while for U.S. investors the decline in the euro would have brought a 3.5 percent loss this year in those government debt securities.

But further dollar declines could change that. The European Central Bank reported last week that June foreign direct and portfolio investment in the euro zone was positive for the first time this year, reflecting stronger foreign demand for European securities. That switch came before the euro began making strides against the dollar in early July.

And a July Reuters survey of U.S. fund managers found many were trimming holdings of U.S. fixed-income assets in favor of European securities. But the survey showed European investors had yet to pull out of U.S. debt securities.

DOLLAR IN THE DOG HOUSE

The Fed's quarter-point rate cut last week, which it said was needed due to weak corporate profits and business investment along with slowing global growth, added to worries about the U.S. economy and caused the dollar to weaken more.

Bill Gross, managing director of Pacific Investment Management Co. (PIMCO), one of the world's largest bond funds, warned last week a weak dollar could spark foreign investors to pull out of U.S. stocks, Treasuries and corporate bonds.

Foreign investors have been large buyers of the record $395 billion of high-grade debt issued by U.S. companies this year.

Analysts at Deutsche Banc Alex. Brown said foreign investors have bought 43 percent of primary corporate issues in 2001 and own 25 percent of the U.S. corporate bond market.

``As these investors' currency gains diminish with a weaker U.S. dollar, the incentives to liquidate their holdings could rise,'' said Ifty Islam, head of U.S. fixed-income strategy at Deutsche, in a recent research note to clients.

But fund managers say they have seen little foreign selling of U.S. corporate bonds, though discussions have swirled about the impact of further dollar weakness.

In one sign that the hunger to hold U.S. securities has not let up, an auction of benchmark notes from Fannie Mae, the largest U.S. provider of housing finance, saw heavier than usual demand from foreign investors.

U.S. INVESTORS LOOK ABROAD

This is occurring just at U.S. investors are also being lured to the prospects of better returns in Europe. The year-long U.S. bond market rally could stall as the Fed nears the end of its aggressive rate-cutting campaign.

``We've come to the view that euro-based debt does look better,'' said John Pool, who helps oversee $11.8 billion in fixed-income assets at Mellon Private Asset Management in Boston. Pool said he has recently shifted to an overweight position on European debt.

http://dailynews.yahoo.com/h/nm/20010902/bs/markets_worldbonds_dc_1.html

-- Martin Thompson (mthom1927@aol.com), September 02, 2001

Answers

B.S. How many times have I read this very same story--something like the last 40 years? The dollar is the world currency of last resort. When worst comes to worst in the world economy, money--from everywhere--will fly into U.S. investments, primarily into our U.S. bond market. Short of gold, U.S. treasuries are the haven of last resort.

-- JackW (jpayne@webtv.net), September 03, 2001.

Moderation questions? read the FAQ