Why was the US dollar rising as Aussie stocks were falling?

August 20th, 2007

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Over the previous weeks, stock prices around the world had been falling. The Australian stock market is no exception. Strangely, in reaction to the tumbling of stock prices, the US dollar rose against many major currencies except the Japanese yen. The rise of the Japanese yen against the US dollar can be explained by the reversal of the yen carry trade (see Another source of potential financial crisis?reversal of yen carry trade). But what about the rise of the US dollar?

There are a three theories we can think of. The first two can be found in Dollar’s fall is no bad thing in the Sydney Morning Herald:

1. The US dollar is rising because the market turmoil prompted a flight to the ?safety? of the US dollar.

2. The US dollar is rising because it is part of the reversal of the yen carry trade.

The third theory is this:

3. A lot of debt (e.g. margin lending for hedge funds) is denominated in US dollars. The credit problems in the US resulted in a surge in the demand for US dollars to repay those debts. Thus, to raise those US dollars, funds had to sell whatever financial assets that they can get their hands on. For overseas assets (e.g. Australian stocks), this means selling them and buying US dollars with foreign currencies (e.g. Australia dollar).

Of the three theories, we feel that the first one is most likely to be wrong.