ECB's Nowotny: No Dollar Shortage in Europe Anymore

Often disputes over the past are really disputes over the present and future. This seems true about the dollar now. One camp argues that the dollar's rally in H2 08 and Q1 09 was a function of safe haven flows. As the acute phase of the crisis abated, the safe haven was not needed and the dollar has generally weakened in Q2 and through Q3 as the safe haven flows were unwound.

The other camp argues that while their was some safe haven demand, the real driver of the dollar's recovery was short-covering. That is to say that the dollar was used as a funding currency--for European banks expanding their balance sheets, for hedge funds buying commodities and emerging markets--Russians, Mexicans, Koreans, and Brazilians, among others borrowed dollars and repatriated the funds to invest at home with higher.

The first camp does not appear to recognize the significance of what appears to have been one of the Federal Reserve's most successful programs. The currency swap lines with foreign central banks. At their peak they amounted to nearly $650 bln. Today less than $70 bln. Those swap lines was to help ease the dollar shortage. The media also appears to have lost sight of this an instead seemed almost enamoured with the fact that China entered into $90 bln of currency swap lines. The Fed's swap lines helped avoid turning the financial crisis into a currency crisis.

In recent weeks, the interest in dollar auctions in Europe has waned and the ECB's Nowotny noted that there was not demand at today's longer-dated dollar auction.

One of the implications of the first camp's views is that the market is overweight dollars and the Q2-Q3 decline can be explained be the diversification of these dollar holdings. There seems to be a kernel of truth in this, but seems largely limited to US investors, who are among the largest cross border equity investors. Public and proprietary data indicates Americans have moved back into overseas markets this year.

However, foreign investors seem under-weight US equities and the dollar. It does not mean they cannot get shorter, but the point is that what the first camp misses is that the dollar again has become a funding currency and that is again the source of its weakness.