Diversification into Dollars ?

There has been more talk of central banks moving out of euros into dollars. As far as we can tell, the only confirmation appears to be Russia. Despite its campaign for an alternative to the US dollar, recent comments by the central bank suggest the dollar's share of Russian reserves have increased and it is not simply on a valuation basis.

On a slightly different front, we note that Japan's Post Bank, the largest bank in the world in terms of deposits bought US dollar bonds for the first time since 2006. Its dollar bond holdings rose to $9.4 bln from $335 mln at the end of Sept 2009. It had no dollar bond holdings at the end of the previous fiscal year (March 2009).

We correctly anticipated the rise of dollar reserves in the latest COFER data that covered Q4 09. The next report is due at the end of next month. We anticipate the dollar's share of reserves rose again in Q1 10. The combination of custody holdings at the Federal Reserve for foreign central banks and the shift in the dollar's value in the foreign exchange market point to the likely increase in the dollar's share of global foreign exchange reserves. In Q1, euro decline almost 5.7% against the dollar and sterling fell 6.1%. The yen was little changed, losing about 0.5%.

The dollar has continued to rise here in Q2 and this bodes well for the dollar's share of global reserves as well. Some pundits see this as the opposite of diversification, but this seems true only in the narrowest senses. Japan's Post Bank for example is diversifying by buying US dollar bonds. Many European fund managers seem to have been underweight US equity exposure. In recent years the combination of the weakening US dollar and under-performance of the US market provided powerful incentives to be under-exposed. The current environment sees the opposite--better outlook for the dollar and US economy-- and this may encourage a diversification back into the US.

In the latest euro zone data that covered the month of March, foreign investors sold 6.9 bln euros worth of bonds. The size may not seem very large, but is still very important because 1) foreigners were net buyers last year of 225 bln euros worth of European bonds and 2) with large supply of European bonds this year, foreign investors were counted on to be active buyers this year. It is true that the ECB is buying sovereign bonds in the secondary market, but the size appears quite modest at this juncture.

The ECB wants to sterilize those purchases, but continues to be coy about the size that it is doing. It has reportedly stripped out details of them in its daily market reports. Observers are trying to back into estimates by looking at the sterilization efforts. Last week the ECB accepted 16.5 bln euros for its term deposits (however some 223 banks wanted to give the ECB a total of 162.7 bln euros to earned 0.29% at an annualized pace).