US Dollar To Benefit as Traders Bet on Swift Economic Recovery

20 November 2008 00:54:54

by Ilya Spivak, Currency Analyst

(DailyFX) Forex traders saw the US dollar rise sharply in the early stages of the credit crunch despite disappointing US economic fundamentals. The appreciation was driven by demand for USD-denominated “risk-free” assets, with capital rushing out of stocks, commodities, and high-yielding currencies to seek safe haven in long term US Treasury bonds. Indeed, we had found an 82% inverse correlation between the 30-year Long bond and EURUSD.

As the crisis has progressed, the US dollar has continued to attract risk-averse investors but the correlation with fixed income instruments has evolved. The inverse correlation between EURUSD and the 30-year bond is now down to just 50%. However, the correlation becomes progressively stronger for shorter-term maturities of US Treasuries. While the EURUSD exchange rate is still only 55% inversely correlated with the 10-year US Treasury Note, the relationship strengthens dramatically to show an 88% inverse correlation with the 5-year note and a hefty 93% inverse correlation with the 2-year note. Clearly, risk-averse investors seem to be shifting from a preference for long-term bonds to short-term ones.

What does this mean? Investors tend to prefer short-term bonds if they expect interest rates to go up. A trader does not want to lock himself in for a long period of time at the fixed interest rate that the bond promises him if he expects to be able to get a better rate in the market before the bond’s expiration. Central banks raise interest rates to curb economic growth and tame inflation. It seems that the same traders that are piling up on dollar-denominated assets out of risk concerns today are also betting on a swift recovery for the world’s top economy, bolstering the case for US dollar appreciation far beyond the exhaustion of the rally’s current catalysts.