Dollar Returns to the Top, and Euro Hits a Tipping Point
By TOM LAURICELLA
Investors retreating from economic and financial uncertainty around the world gave a boost to the bruised U.S. dollar in the third quarter.
The dollar's strength came most notably against emerging-market currencies, which posted sharp, sudden declines against the U.S. currency in September.
Many investors had believed emerging-market economies would prove resilient in the face of the challenges facing the developed world, thanks to their relatively strong economies and healthy fiscal positions. But, finally, as Europe and the U.S. inched closer to possible recession, the drag from the developed world proved too great to bear.
"The decoupling thesis of the world finally gave way to the recoupling one," said David Woo, currency strategist at Bank of America Merrill Lynch. "The exodus from emerging markets gave the dollar a big boost."
It wasn't just the dollar that investors sought for safety. The yen also gained, despite Japan's own economic woes. And, during July and August, the Swiss franc surged, thanks to money pouring in from elsewhere in Europe. The franc's rise, however, ended abruptly in early September, when the Swiss National Bank, worried about the growing damage to the Swiss economy from the currency's surge to record highs, effectively pegged its currency to the euro.
The currency markets go into the final quarter of 2011 with the outlook seen as hinging on how European officials handle the Continent's crisis. Also crucial will be whether the U.S. and Europe can avoid slipping back into recession.
The dollar's strength was virtually across the board, including against the euro, which finally succumbed to worries about the debt crisis. The euro finished the third quarter at $1.3387, a nearly 8% drop from $1.45 at the end of June. The big exception for the dollar was its performance against the yen, where it fell more than 4% thanks to that currency's own flood of safe-haven buying.
Meanwhile, the Australian dollar slumped 10% against the U.S. dollar, falling below parity for the first time since the spring. The Canadian dollar fell 8% against the U.S. dollar.
The dollar's biggest gains came in September, at the expense of currencies from emerging markets and commodity producers.
The dollar surged 16% against the Brazilian real for the quarter, 11% against the Korean won and 20% against the South African rand. Much of the damage came as investors scrambled to exit from bond holdings denominated in local currencies in Asia and Latin America.
"These were very, very crowded trades," Merrill's Mr. Woo said.
Ripples from the European crisis may have upended emerging-market currencies, said David Mann, currency strategist at Standard Chartered Bank.
![[dollar]](http://si.wsj.net/public/resources/images/OB-PQ312_dollar_D_20110914080841.jpg)
Reuters
Where the currency markets go in the final months of 2011 and beyond will largely depend on the fate of the euro zone and its leaders' ability to keep the crisis from spreading beyond Greece, many investors said.
Many companies in emerging markets, especially in Asia, had relied on European banks for short-term borrowing of U.S. dollars. However, as worries intensified about the exposure of European banks to Greek and other stressed peripheral-country debt, it became harder for those banks to borrow money. That, in turn, made it more difficult for emerging-market companies to roll over their dollar loans, Mr. Mann said.
As a result, companies started turning to the currency markets for short-term dollar funding—they entered into "swaps" in which they bought dollars in the cash market and committed to selling them in the future. These trades, Mr. Mann said, "usually are dollar-positive." That may have helped fuel the broad retreat from emerging-market currencies.
At the same time, there was a general move by investors to pare back on riskier investments, such as those in emerging markets.
That, says Alessio de Longis, portfolio manager at OppenheimerFunds, meant investors were cashing out of emerging-market currency positions and moving back into dollars. "The theme of this quarter was repatriation."
With U.S. investors the largest source of investment capital around the world, the biggest beneficiary was the dollar, Mr. de Longis said.
Where the currency markets go in the final months of 2011 and beyond will largely depend on the fate of the euro zone and its leaders' ability to keep the crisis from spreading beyond Greece, many investors said.
For weeks, "every single conversation, whether it's about Asia, the Middle East or Africa, started and ended" with Europe, Mr. Mann said.
A related issue is the threat of recession in Europe and the U.S., Mr. de Longis noted. "We're a little bit concerned," he said. "We think it's worth being on the sidelines." Longer term, however, Mr. de Longis said the dollar's multiyear "down" trend should resume, especially against emerging-market currencies.
Merrill's Mr. Woo, however, is positive on the outlook for the dollar. He thinks the Federal Reserve won't engineer another round of quantitative easing before next year's presidential election unless the U.S. economy gets much worse.
Meanwhile, Mr. Woo said, ineffective monetary policy and political paralysis in the U.S. will put the onus on other countries around the world to lower rates to avoid recession. "The rest of the world will have to do a lot more work, and that's the best news you could have for the U.S. dollar," he said.
