Friday, September 11, 2009

The dollar, Treasuries, and a Reassessment of Risk Tolerance

Over the past week or so, many stories have focused on the falling dollar. Some of the stories are legitimate threats to the dollar, such as China beginning to assert itself by issuing yuan-denominated debt to Hong Kong (, and others merely make headlines, like the UN declaring the need for a new reserve currency (

Both stories are the type of news that would normally cause traders to react by sounding the alarms of a dollar crisis, and the dollar has indeed made new lows for the year. However, there is no evidence of any kind yet that the dollar weakness is causing foreign investors to become apprehensive toward the U.S Treasury market. The Treasury held three successful auctions for 3- and 10-year notes as well as 30-year bonds, all of which produced strong bid-to-cover ratios and showed evidence of solid foreign participation. The question of whether or not bond investors have a great fear of oversupply (due to tge deficit) or inflation, seems to have been answered- at least for now. The current environment is one within which investors of various degrees of risk tolerance feel increasingly confident seeking opportunities.

Does this mean that U.S. bonds are decoupling from the declining dollar? Maybe not, completely, but it does demonstrate a conviction that there is no significant risk of interest rate increases in the foreseeable future. Ben Bernanke has been adamant about deflation prevention since the onset of the crisis and his words have assured markets that the Fed remains committed to facilitating a sustainable economic recovery. As a result, the prevailing view seems to be that the fed funds rate will remain trapped against the zero lower bound for some time, therefore helping prevent any major back-up in Treasury yields. As such, the strong bonds bids this week do not reflect a flight to safety, but a legitimate investment opportunity sprung out of the strong appeal of such securities on a carry basis.

In addition to U.S. debt, and further along the risk spectrum, many other asset classes, including gold, SPX, most currencies vs. USD, and global equities have risen, indicating a reflation of sorts. This makes sense, given the cautiously optimistic economic numbers overseas, particularly among emerging markets. It has been made apparent that the U.S. will not lead out of this downturn and, as such, it makes limited sense to pile cash in money markets when more attractive returns are available in most asset classes across the board. Some of the most rich investment opportunities are to be found in the places that have already begun traveling the road to recovery, or better yet, don't have much recovering to do, and recent price action indicates that the markets seem to be recognizing that fact.

Chris Hodge
Analyst, Pharo Management

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