currency

he $ fell last week to the lowest level in a year as price swings in foreign exchange declined, encouraging investors to borrow greenbacks at record low interest rates and buy assets in countries offering yields as much as 8.1 percentage points higher than U.S. deposit rates. Borrowing costs in dollars as measured by London interbank offered rates fell below those of and Swiss francs for an extended period for the first time since 1994 during the past three weeks.

Thoare the most profitable since before 2000, according to data compiled by Bloomberg. Borrowing dollars and then selling them is adding pressure on a currency that’s already weakened 14 percent since March as the budget deficit exceeded $1 trillion, the government sells a record amount of debt and the Federal Reserve floods the financial system with $1.75 trillion to pull the economy out of a recession.

“The dollar is the big funding currency,” said , vice chairman of New York-based FX Concepts Inc., the world’s largest currency hedge fund, with $9 billion in assets under management. “The reason why people are borrowing the U.S. dollar for carry trade is A: It’s very cheap to fund, and B: The expectation is it’s going to go down.”

Risk Versus Returns

London-based Standard Chartered Plc, the most bearish of 45 firms in a Bloomberg survey, predicts the dollar will decline 6 percent versus the euro by year-end. Deutsche Bank AG in Frankfurt, the most accurate forecaster of the dollar in the first half of 2009 as measured by Bloomberg, is bullish, calling for it to gain 11 percent by the start of 2010.

Using the world’s reserve currency to fund carry trades became more profitable and less risky last month than with the yen for the first time since March 2008, Bloomberg data show. The difference in Sharpe ratios for dollars and yeof performance versus risk, has averaged 1.35 since May, compared with minus 0.37 since 2004. The higher the Sharpe ratio, the higher the risk-adjusted return.

“The way everyone is funding their risky investments is by using dollars,” said the head of foreign-exchange strategy at Frankfurt-based Deutsche Bank, the world’s largest currency trader. “Interest rates between Japan and the U.S. are fairly comparable right now, which is incredibly unusual. Much of the past 20 years or so, the yen has been the funding currency of choice.”

29% Return

The three-month for dollars, a benchmark for about $360 trillion of financial products, fell today to an all-time low of 0.295 percent, compared with 0.355 percent for the yen and 0.305 percent for the Swiss franc, another traditional funding currency, according to the British Bankers’ Association in London. Over the past 20 years dollar Libor has averaged almost 3 percentage points more than yen Libor.

An investor who borrowed $10 million dollars in March to fund the purchase of a basket of 10 currencies including the Brazilian real and South African rand would have paid 1.27 percent initially. The trade would have delivered a 29 percent return through last week as the offshore funding rate dropped to 0.53 percent, according to three-month deposit rates for the currencies compiled by Bloomberg.

That same strategy funded in yen would have returned 19 percent with wider swings in daily returns, Bloomberg data show. That trade funded in francs would have earned 16 percent.

Real, Rand

The basket comes from the most actively traded currencies in the Bank for International Settlements’ triennial survey that offer the highest three-month rates. Brazil’s benchmark is 8.6 percent and the real has appreciated 26.4 percent this year. South Africa’s borrowing rates are 7.2 percent. The rand has strengthened 28 percent compared with the U.S. currency.

Volatility, which can wipe out gains from carry trades, also favors using the dollar over yen. Three-month euro-dollar volatility fell to 10.2 percent on Sept. 11, while three-month dollar-yen volatility declined to 11.9 percent. The difference is the biggest since December.

Record low borrowing costs, designed to help pull the economy out of the deepest slump since the Great Depression, may be hurting the dollar more than supporting it. The Fed and Chairman cut the target fed funds rate to a range of zero to 0.25 percent in December, from 5.25 percent in September 2007.

Dollar Index

The Dollar, which tracks the dollar against the euro, yen, U.K. pound, Canadian dollar, Swiss franc and Swedish krona, rose 17 percent from Sept. 15, 2008, to March 5, 2009, as investors sought the safety of U.S. assets following the collapse of Lehman Brothers Holdings Inc. and the government’s bailout of insurer American International Group Inc. When the panic receded, the index fell 14 percent to 76.972 today as investors focused on deficits in the U.S. and interest rates.

Investor appetite for dollars may benefit from the growing gap between short- and longer-term borrowing costs in the U.S., according to a foreign-exchange strategist at Barclays Bank Plc in Tokyo.

Yields on 10-year Treasuries ended last week at 2.44 percentage points more than two-year notes, the third-widest spread of any Group of 10 nation after the U.K. and Sweden. The so-called yield curve in Japan is 1.10 percentage points.

Rate Outlook

Policy makers may also help the dollar appreciate, at least against the euro. The European Central Bank will wait until the final quarter of 2010 to increase its mark rate from 1 percent, according to Euribor interest-rate futures. The odds that the Fed will raise its target rate for overnight bank loans as soon as the second quarter are almost 59 percent, fed funds futures on the Chicago Board of Trade show.

For now, the U.S. currency is weakening after the budget deficit expanded to $1.27 trillion in the first 10 months of fiscal 2009 that ends Sept. 30. The gap will widen to $1.6 trillion in 2010, according to the Congressional Budget Office.

The Obama administration has pushed the nation’s to an unprecedented $6.78 trillion to spur growth, support the financial system and service record deficits. The Fed is pumping in $1.75 trillion to keep credit flowing by purchasing Treasuries and mortgage bonds.

The drop in the U.S. currency has contributed to a 9.4 percent gain in theIndex of 19 raw materials. Gold has risen 13 percent this year to about $1,000 an ounce, while crude oil has soared 53 percent to $68.21 per barrel.

Last week, Standard Chartered reiterated its call for the dollar to weaken to $1.55 per euro by year-end, from $1.4571 on Sept. 11. Zurich-based UBS AG, the world’s second-largest currency trader, lowered its forecasts last week for the dollar.

Yen Volatility

Royal Bank of Scotland Group Plc in Edinburgh will probably raise its year-end yen forecasts to “the order of 88 versus the dollar and 122 versus the euro” Greb gires a foreign-exchange strategist in Sydney, wrote in a report last week. The yen ended Sept. 11 at 90.71 to the dollar and 132.17 to the euro.

Yen volatility may increase after the Democratic Party of Japan and two other political parties take power in Japan for the first time this week, according to, a senior currency trader at Mizuho Corporate Bank in New York.

The DPJ needs to find 7.1 trillion yen ($78.3 billion) to fund its election pledges in the year starting April 1, and the amount would swell to 16.8 trillion yen in 2013, according to its campaign manifesto. The new administration, led by Prime Minister-designate Yukio has said it will increase funds for child care, education and employment partly by diverting as much as 5 trillion yen of stimulus spending already approved.

“People are watching what this new government will do in this new era,” said Yanagihara. “That will cause higher long- term interest rates and maybe the budget deficit will inflate.”