MINING FINANCE / INVESTMENT

Heads up on currency plays and the impact of the dollar on commodities.

Global policy interest rate directions in play as the dollar and yen take a breather. The impact on commodities and currencies where commodities are key to local economies, is already beginning to be seen.

JOHANNESBURG - 

After trading at multi year lows on Tuesday this week, the dollar index took a breather before, and following, Wednesday's decision by the Federal Reserve, the US central bank, to cut its policy interest rate by 50 basis points to 1%.  The yen, which, like the dollar, has staged a huge multi month rally, is also breathing easier.

The changing value of the two currencies, backed by the two biggest economies in the world, is of critical importance to investors everywhere. The dollar index (the weighted geometric mean of the dollar's value against a basket comprising the euro, yen, pound sterling, Canadian dollar, Swedish krone and Swiss franc) moved to 87.88 points on Tuesday, its highest level since April 2006. However, the trade weighted dollar index, which includes a bigger collection of currencies than the US dollar index, has been even stronger recently, trading close to three year highs.

The dollar has been in recent favour following the crisis that swamped global markets, especially since 15 September 2008, when Lehman Bros., the erstwhile Wall Street investment bank, filed for bankruptcy. The massive deleveraging mounted by investors saw asset sales of all kind, with US Treasury bills providing a natural home for the resulting cash.

As for the yen, it has increasingly emerged that the currency has been in massive demand as investors unwind so-called carry trades. These occur when speculative investors borrow cash in a low interest rate jurisdiction, and invest where rates are high. Japan's interest rates are the lowest in the world; the three-month rate is just 0.79%, while 10-year government bonds yield 1.54%. Following the explosion of risk aversion, investors have created heavy demand for yen as carry trades are reversed to route investments into cash, pushing the yen to multi year highs.

Until around 15 July 2008, there had been little enthusiasm for either the dollar or the yen. The dollar index entered a protracted bear market early in 2002, and touched a long term cyclical low in April this year, and then another near-low on 15 July, from where it appreciated rapidly by 22% to the multi year high earlier this week.

The dollar's recent strength aggravated headwinds faced by commodities - already facing a slowing global economy - given the inverse correlation between dollar-denominated commodity prices and the dollar. This has contributed to the depth of sell off of various currencies exposed to dominant resources sectors, such as the Australian dollar, which has retrenched more than 30%.

Emerging market currencies have also been targeted, for various reasons: the Chilean peso (huge exposure to export copper earnings), the South Korean won (perceptions of a weak banking system), Pakistani rupee (political unease), Hungarian forint (large current account deficit), and South African rand (large current account deficit, and heavy exposure to export mining earnings).

The Bank Credit Analyst reckons that, given extreme volatility in markets, "it remains too early to make large currency bets. Once the panic subsides and financial stress eases, our strategy will have three pillars.

"First, the euro and pound will be ‘trading buys' against the dollar and yen, but no more than that. The European economies and financial systems will be soggy for some time, and their central banks are still behind the curve.

"Second, the trade-weighted dollar is close to a three-year high, which will not make economic sense even after the US economy and banking system turn the corner. Most likely, the dollar will lose ground against emerging and commodity currencies with good fundamentals, but will hold its own against the euro.

"Finally, the yen is a tougher call and we recommend standing aside. On economic grounds, the currency is a sell the minute that investor risk aversion peaks. However, the Japanese balance of payments warns that policymakers would have to knock down the yen. The private sector has been burned on foreign investments too often, and any renewed Japanese ‘stretch for yield' will be moderated by interest rate cuts around the globe".