Dollar faces crosswinds: report

BIS said in its quarterly report on Sunday that several factors helped fuel a surge in the dollar in late 2008 -- safe-haven flows, unwinding of dollar-funded carry trades, a shortage of dollars in the global banking system due to a spike up in dollar money market rates, and squaring of overhedged positions by non-US banks and institutional investors.

The dollar is still drawing support as non-U.S. banks continue to write down the value of their dollar assets and so have to hedge that exposure, and there is still demand for dollars in foreign exchange swap markets, the BIS said.

However, as markets continue on the road to recovery this year, the dollar is back under pressure.

Investors are once again borrowing cheaply in dollars and using those funds to buy higher-risk and higher-yielding currencies and assets in so-called carry trades, and safe-haven inflows that boosted the dollar in late 2008 have reversed.

Looking ahead, the factors reviewed ... make for crosswinds for the dollar, the BIS said.

Safe haven flows that favored the dollar have been reversing. Carry trades always defy measurement, but such positions, with the dollar as a funding currency, are thought to be increasing, putting upward pressure on higher-yielding currencies.

The dollar recently hit a 14-year low against the Japanese yen at below 85 yen and a 16-month low against the euro at $1.5145 per euro, coming under broad selling pressure from investors confident that U.S. interest rates will remain ultra low well into next year.

But there are still tailwinds for the dollar, the BIS said, noting a premium on dollars in foreign exchange swap markets. Non-U.S. banks continue to write down dollar assets, albeit at a slower pace, which should offer the dollar support as these institutions adjust their hedges.

The dollar rallied broadly last week after the Bank of Japan said it would offer extra liquidity to banks in a bid to fight deflation, contrasting with the Federal Reserve and European Central Bank, which are both in the early stages of withdrawing their extraordinary policy measures.

The dollar's recovery was given an extra boost on Friday by the latest U.S. employment figures which showed far fewer jobs were lost in November than expected and a surprise fall in the unemployment rate.

The BIS also said that in the current environment of low U.S. yields, the dollar was vulnerable to big swings in asset prices and volatility.

In particular, when equities fall, risk appetite shrinks and volatility is increasing, dollars are bought by both types of investors, as in late 2008, the BIS said, referring to carry traders and institutional investors.

With 'risk on', equity prices rising and declining volatility, dollars are sold by both, albeit perhaps at different frequencies, the BIS said.

(Editing by Karen Foster)