Monday, November 30, 2009

FX Briefing : Dubai's Debt Problems Shock Markets

  • Fed minutes reveal relaxed attitude towards dollar weakness
  • Dollar plunges to new lows against euro, yen and Swiss franc
  • Dubai requests debt standstill for state holding company, dollar strengthens
  • ECB embarks on exit, December 12-month tender could be the last

After lacking direction for several weeks, the dollar fell to new lows against various currencies this week. During the course of the week, EURUSD firmed to 1.5144 temporarily, a 15-month high, only to plummet again towards the end of the week. The Swiss franc breached parity (i.e. the 1:1 level) with the dollar, and the dollar tumbled to 84.82 against the yen, its lowest level since 1995.

The reasons for the dollar's plunge to new lows are diverse and complicated, however. The dollar's current weakness is basically connected with a more optimistic assessment of the economic outlook, which is increasing risk appetite. This tendency is spreading as market participants are observing that, compared to the ECB in particular, the US Fed seems to be showing little inclination to end its ultra-loose monetary policy. The ample supply of cheap liquidity is also boosting carry trades, whereby cheap US dollars are used to fund riskier assets world-wide.

Presumably the minutes of the FOMC meeting of 3-4 November prompted the euro's jump over 1.50 against the dollar. At this meeting, the council members discussed the dollar's exchange rates, which is most unusual. They described the dollar's recent decline as “orderly” and interpreted it as the result of a decline in safe haven demand. Many market participants are worried that rising government debt and the loose monetary policy could erode the value of the dollar, but the Open Market Committee does not share this view. The FOMC even seems to be quite amenable to the fact that the weaker dollar is supporting US exports (this is also pointed out in the minutes).

From Thursday, however, EUR-USD tumbled. Towards the end of the week, the euro was back at around 1.49 again. Simultaneously, the dollar strengthened quite significantly against most major currencies, including emerging market and commodity currencies.

This movement was triggered by reports that Dubai World, a government-controlled holding company active primarily in the property and project development sectors and as a port operator, had requested a debt standstill and was seeking to restructure its debts.

Although the total volume of the liabilities directly affected, $59 billion, is not all that high, bond markets reacted sharply to the news, because Dubai's debt problems (S&P are checking whether it is in fact a default) highlight the high credit risks also slumbering in emerging markets. Particularly in the last few months, investors' confidence in emerging markets has grown, resulting in an increase in capital inflows.

The problems in Dubai, where it had been assumed that the government could fend off risks, undermine this confidence. It is not out of the question that risk appetite could wane again and that liquidity in the emerging markets could dry up, as it did after the Iceland crisis. Just before the end of the year, market participants are unlikely to want to put the year's gains at risk unnecessarily.

Equity markets in Asia and Europe slipped, government bonds are exceptionally strong. CDS spreads for Arabic countries widened, particularly for Abu Dhabi. Because of the long Thanksgiving weekend, however, it is uncertain how sharp the reaction in the US will in fact be.

Next Thursday, the ECB governing council is holding its next meeting. The macroeconomic projections, which will be released at the press conference, are likely to show an upward revision of the growth forecast for 2010. Otherwise, there will probably only be slight amendments to the September estimates.

Market participants are likely to focus on the exit from unconventional measures. In the last few weeks, several ECB representatives had hinted that the start of an exit was imminent. It appears to be relatively certain that the ECB will discontinue its 12-month tender next year; the Council is discussing whether to offer the December tender at the main refinancing rate as it has done up to now. As an alternative option, it is considering calculating the tender rate on average refinancing costs during the maturity period. This would be complicated and presumably prohibitive. Furthermore, it would suggest restrictive interest rates.

Whether further restrictions to long-term refinancing operations for 2010 will be announced remains to be seen. In the past months, however, demand for these tenders has dropped significantly, so that curtailing the offer would not cause a serious problem. On the other hand, it would not be a problem either to continue to offer the 3 or 6-month tenders for the time being.

This report has been prepared by BHF-BANK Aktiengesellschaft on behalf of itself and its affiliated companies (together "BHFBANK Group") solely for the information of its clients.
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