| Dollar depends on foreign investments { June 2007 } Original Source Link: (May no longer be active) http://www.reuters.com/article/reutersEdge/idUSN1723486720070717http://www.reuters.com/article/reutersEdge/idUSN1723486720070717
Dollar support may hinge on equity inflows Tue Jul 17, 2007 7:05PM EDT
By Steven C. Johnson - Analysis
NEW YORK (Reuters) - The dollar's fortunes in the months ahead may rest on foreigners' taste for U.S. equities, especially if defaults on bonds backed by risky mortgage debt continue to rattle confidence in the U.S. credit markets.
Overseas investors in May poured a record net $42.5 billion into U.S. stocks, according to U.S. Treasury data released on Tuesday.
While they also more than doubled net purchases of corporate bonds, the surge in stock buying may signal a shift in foreign preferences when it comes to U.S. assets.
That would mark a big change. Over the past four years, low global interest rates have sent yield-hungry investors pouring into U.S. fixed income securities, providing a bedrock of support for the dollar and a key source of financing for the U.S. current account deficit.
In the first quarter of 2007, foreigners bought $133.7 billion in U.S. corporate bonds -- effectively financing more than two-thirds of the $192.6 billion current account shortfall for that period. In the 12 months to May, they snapped up $582 billion.
But a deepening housing slump, set off by defaults and losses on risky mortgage debt, may prompt foreigners to steer clear of U.S. credit markets in the months ahead.
Daniel Katzive, senior currency strategist at UBS in Stamford, Connecticut, says that likely weighed on the dollar over the last month, pushing the euro to an all-time high above $1.38, and could show up in next month's Treasury data.
"If we're moving into an environment when equity markets consistently outperform credit, it's important for the dollar that the U.S. attracts increased equity inflows," he said.
Because it spends far more than it saves, the United States needs to attract some $3 billion every working day to finance a current account gap that exceeds 6 percent of total output.
A failure to do so would put further pressure on the dollar, which on a trade-weighted basis has declined some 16 percent in the past four years to July, and potentially drive up inflation and interest rates.
BULLISH ON EQUITES
Foreign inflows into bonds still dwarf those into equities, a trend that's lasted for the last four years or so largely because China and other Asian countries' export-led economies have flooded them with excess reserves that their central banks recycle into U.S. Treasury debt.
But in the current global economic environment, many see equities as a more attractive investment.
Chris Probyn, chief economist at State Street Global Advisors in Boston, said annual global growth above 5 percent and oil flirting with record highs near $78 a barrel should lead to higher global interest rates.
"Then, you spice things up with the problems in the U.S. subprime mortgage market, and you see that bonds look particularly vulnerable," he said.
Equities, though, look set to benefit from strong global growth, robust corporate profits and interest rates that remain far from what Probyn called "prohibitively high levels."
A weak dollar is also seen continuing to boost the profits of U.S. blue chip companies such as IBM (IBM.N: Quote, Profile, Research) and Coca-Cola
(KO.N: Quote, Profile, Research).
"Non-U.S. investors should see some reasonably attractive stocks among the U.S. large caps with big overseas earnings and a large global footprint," said Chris Orndorff, who oversees $50 billion in assets at Payden & Rygel Investment Management in Los Angeles.
Increased equity inflows could spark a modest dollar rebound against the euro and sterling, which traded at a 26-year high this week.
It could also boost dollar gains against the low-yielding yen, particularly given that Japan's Nikkei (.N225: Quote, Profile, Research) has been a laggard among major world indexes over the past few years.
"The dollar looks pretty cheap to most people," said Richard Batty, who helps manage some $76.5 billion in assets for Standard Life Investments in Edinburgh.
He said foreign investors are attracted by Standard & Poor's 500 index price-to-earnings ratios of 16 times estimated 2007 forward earnings, adding a cheaper dollar "means they're not overpaying for assets."
Of course, one month does not make a trend, and analysts have pointed out that until May, U.S. investors had been big buyers of overseas stocks, a dollar-negative outflow.
Meanwhile, a widening of corporate bond spreads -- the extra yield over comparable Treasuries that investors demand for holding riskier debt -- should produce some bargains.
"We're not raising the red flag yet regarding flows into corporate debt," said CMC Markets strategist Ashraf Laidi.
But Katzive said the foreign preference for bonds can't last forever. "You have to remember that this obsession with yield has been with us only for a few years," he said. "It has not always been the be-all and end-all of FX inflows."
© Reuters 2006.
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