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Dollar Struggles to Hold its position
Throughout the month of August foreign investors were seen to reduce their purchases of dollar denominated securities with the total net Treasury International Capital flows rising by only $38.9B compared to $63.3B the previous. Whilst foreign demand fell nearly 50 percent in August, the details were not nearly as negative as the headline report because demand for Treasuries was very strong, a sign that central banks and private investors expect U.S. yields to remain very low.

Net long term securities actually rose by $128.7B and the gap was made up by a sharp decline in the net dollar denominated liabilities on non-dollar denominated holdings of banks, which is updated quarterly. This line item basically tracks the banks' own liabilities to foreigners in the form of deposits from foreign residents into U.S. banking institutions and borrowings from foreign residents.

The TIC report shows strong demand for dollars from the U.K., China, Japan and hedge funds in the Caribbean. Countries like Brazil and Korea were also net buyers. It is important to note that the dollar actually rallied in the month of August and therefore this data does not tell us how foreign demand has changed since the dollar collapsed in September. We don't expect Japan, Brazil and Korea's appetite for dollars to change - in fact it has probably strengthened because of intervention last month. China on the other hand allowed their currency to hit a record high which means they may have cut back their demand for dollars materially. In the meantime however, they still remain the world's largest holder of Treasuries, boosting their purchases by $21.7B compared to Japan's $15.6B purchases. Since the beginning of the year, the gap between Japanese and Chinese holdings has narrowed significantly although it appeared to have expanded once against in August.

Meanwhile profit taking continues to help the dollar recover despite weaker economic data that validates the need for additional stimulus. Industrial production fell 0.3 percent in September while capacity utilisation dropped from 74.8% to 74.7%. The surprise decline was the first negative print since June 2009 which indicates that a weak dollar has failed to help the manufacturing sector. This also explains why the U.S. government is pressuring China to revalue its currency because even a weak dollar has failed to help reinvigorate the U.S. recovery.

Investors have been buying back dollars since Bernanke spoke on Friday because even though the central bank head confirmed that additional easing will be necessary, Quantitative Easing has been priced and now currency pairs such as the EUR/USD and AUD/USD have been hit by a big wave of profit taking. Of course it also did not help that Trichet denied any plans to end its bond purchase program, which was seen as a step towards tighter monetary policy. The British pound has weakened the most on speculation that the Bank of England could join the Federal Reserve in expanding their asset purchase program by as much as GBP100 billion.

The one currency that has not sold off materially is the Australian dollar because despite the Aussie climbing to parity on Friday, Australian officials maintain a very laissez faire attitude towards the currency. Instead of warning about the negative impact of a strong currency, the Treasurer said last night that it is "dangerous to seek to artificially lower the value of the Australian dollar."