US Apathetic about Dollar

Recently, it struck me: the US does not care about the Dollar. If you look at fiscal and monetary policy, there is actually a remarkable degree of consistency. Both reflect a clear disregard for the conditions that are necessary for a strong currency.

This might seem ridiculous, given the Dollar’s amazing performance of late. It has appreciated healthily against almost all of the world’s major currencies, and is also more valuable on a trade-weighted basis. Bear in mind, however, that this rise is entirely a function of the (perceived) crisis in Europe. It speaks not to any strength in the Dollar, but rather to weakness in other currencies. In fact, as I wrote earlier this week (”US Dollar Paradigm Shift“), as investors have returned their gaze to the fundamentals, the Dollar has suffered.

Without drilling into the nuts and bolts of US fiscal policy, consider that the US budget deficit will exceed an unthinkable $1 Trillion for a second year in a row. The national debt is now growing much faster than GDP, and servicing it is consuming an ever-increasing share of the budget. With concerns looming of a double-dip recession, meanwhile, tax revenues will probably stagnate, even regardless of what happens to spending. In short, US budget deficits are going to continue to be a fact of life for the immediate future.

Monetary Policy is equally disastrous. The Fed is pre-occupied with keeping interest rates low and with promoting an economic recovery. $2 Trillion of newly-minted money is still flowing through the system, and it’s unclear when it will be siphoned out. There are a few inflation hawks on the Fed’s Board of Governors, but they lack the power to effect a short-term change in monetary policy.

The Bank for International Settlements (BIS), G20, and a pair of economists, among others, have all sounded alarm bells, calling such policies foolish and unsustainable. According to the BIS, “Keeping interest rates very low comes at a cost—a cost that is growing with time. Experience teaches us that prolonged periods of unusually low rates cloud assessments of financial risks, induce a search for yield and delay balance-sheet adjustments.”

In short, there is a clear consensus that perennial budget deficits and low rates are wrongheaded at best, and disastrous at worst. From the standpoint of currency markets, what matters in the short-term are interest rates, and what matters in the long-term is inflation. The Dollar is in an unfavorable position on both fronts. Interest rates are currently near 0% – the lowest in the world – and easy monetary policy and high government debt increase the likelihood of inflation in the wrong-term.

In light of this notion, the only logical conclusion is that the Dollar simply plays no role in the formulation of government and Central Bank decision-making. Since the inception of the credit crisis, this was a luxury that could be afforded, as safe-haven capital poured into the US. If/when the crisis abates, this capital will probably depart, as investors are forced to consider the fundamentals.

Since my last update in June, the Japanese Yen has continued to creep up. It has risen a solid 5% in the year-to-date against the Dollar, 12% against the Pound, and an earth-shattering 20% against the Euro. It is closing in on a 15-year high of 85 Yen/Dollar, and beyond that, the all-time high of 79. According to the Chicago Mercantile Exchange, “Long positions in the yen stand at $5.4bn. This is the highest level since December 2009 and represents the biggest bet against the dollar versus any currency in the market.”

usd-jpy 1 year chart
As to what’s propelling the Yen higher, there is very little mystery. Two words: Safe Haven. “The yen’s attractions lie in its status as a haven from the turmoil that has engulfed financial markets as, first, the eurozone debt crisis unfolded and, then, fears about a double-dip recession have intensified.” To be sure, there are a handful of currencies that are arguably more secure and less risky than the Yen. The problem is that with the exception of the Dollar, none of them can compete with the Yen on the basis of liquidity. In addition, thanks to non-existent inflation in Japan and low interest rates in other countries, there is very little opportunity cost in simply holding Yen and simply taking a wait-and-see approach.

According to some analysts, interest rate differentials will probably remain narrow for the foreseeable future: “Global bond yields will fall, reducing the incentive of yen-based investors to place funds abroad.” In fact, thanks to low interest rate differentials, the Yen is not even the target funding currency for carry traders. Suffice it to say that investors are not bothered by the fact that Japanese monetary policy is extraordinarily accommodative and that Japanese long-term interest rates are the lowest in the world. For those who are concerned about rising interest rate differentials, consider that this probably won’t become a factor until the medium-term.

On the fundamental front, there are a couple of risks for the Yen. First of all, there is the stalled Japanese economic recovery and the possibility that the strong Yen could further erode the competitiveness of Japan’s export sector, the mainstay of its economy. Yen bulls respond to this by noting both that Japan’s economic recovery has already stalled for 25 years and that should the Yen’s rise actually crimp economic growth, the Central Bank would probably intervene. By all accounts, “The government will continue to keep a close eye on the yen.”

A greater concern, perhaps, is Japan’s massive debt. Near $10 Trillion, public debt is already 180% of GDP, and is projected to grow to 200% over the next few years. Total public and private debt, meanwhile, is by far the highest in the world, at 380% of GDP. The Japanese government is planning to implement “austerity measures,” but political stalemate and election pressures will make this difficult to achieve. All three of the rating agencies have issued stern warnings, and downgrades could soon follow. Here, Yen bulls retort that as unsustainable as this debt might appear, the majority (90%) of it is financed domestically, through the massive pool of savings. The remaining 10% is eagerly soaked up by foreign investors, who view the debt as a more attractive alternative to cash and stocks. [This is the great irony that I alluded to in the title of this post - that more debt is viewed positively as "liquidity" and does nothing to hurt the Yen].

Japan Public Debt 1980 – 2010

Speaking of which, the Japanese stock market has risen by only 5% this year, and some analysts are predicting that a long bull market is inevitable. Adding to the fervor, Central Banks have begun to build their positions in the Yen, for the first time in 10 years. It seems everyone is excited about the Yen, even economists: “Within the developed economy space, Japan looks relatively good as an economy that’s likely to be growing faster than Europe or America, and it’s generally considered to have low risk of capital flight.” In other words, the consensus is that there is a very low chance of a “Greek-like debt crisis.”

At this point, the Yen can only be toppled by Central Banks: either foreign Central Banks will hike interest rates and make the Yen unattractive in contrast, or the Bank of Japan will intervene directly to prevent it from rising further.

On a trade-weighted basis, the Canadian Dollar (aka Loonie) has appreciated nearly 10% in 2010. At the same time, it has fallen 8% against the Dollar since the beginning of May. This contradiction is reflected in an explosion in volatility: “CAD has been very volatile – the average intraday spread between the high and low in CAD over the last 21-years has been 83 points; over the last month it has been 182 points.” How can we make sense of this uncertainty, and which trend is ultimately more representative?

CAD USD 1yr

On the one hand, the Loonie continues to be thought of as a commodity currency whose rise and fall is closely linked to fluctuations in the prices of certain raw materials. “It’s not just about oil any more, but also natural gas – whose price has carved out a bottom – and precious metals, which command a 13-per-cent share of the TSX’s market cap versus less than 1 per cent for the S&P 500,” observed one analyst. From this standpoint, it’s perhaps not surprising that a 7.2% drop in the Raw Materials Index was matched by a proportional drop in the value of the Loonie.

On the other hand, the Loonie is being punished by the Eurozone debt crisis and the consequent flight to safe haven currencies: “The Canadian dollar is following the risk aversion tones of the market.” While the Loonie might have otherwise been “been closer to parity” then, it’s understandable that the so-called “panic trade” is holding it down.

In light of the Eurozone debt crisis, however, one might have predicted that commodity currencies would rally, since they are perceived as being backed by something more tangible than government fiat. In fact, some analysts believe that the comparatively modest decline in the Loonie implies that this is indeed the case: “It was fascinating to see the Canadian dollar only correct down to 92 cents during this most recent round of global financial turbulence and flight-to-safety. That is a far cry from the correction down to 78 cents following the Lehman aftershock, not to mention the move down to 62 cents after the tech wreck a decade ago.”

The same analyst pointed out that the notion of the Canadian Dollar as a safe-haven currency is further justified by Canada’s strong fiscal condition. It is trimming its spending, cutting taxes, and may even reduce its national debt. Meanwhile, it’s financial system remains robust, as evidenced by the fact that none of its banks have required government bailouts. Thus, Canadian sovereign debt has continued to appreciate in spite of the crisis across the Atlantic. In short, “The federal government actually deserves the triple-A credit rating that it receives on its debt.”

Going forward then, the near-term performance of the Loonie will depend both on the EU sovereign debt crisis and commodities prices, which in turn are high sensitive to (perceptions of) the global economy. In this latter aspect, there is tremendous uncertainty. The Canadian economy did grow at 6% last quarter. However, “The fear is that weaker U.S. data is posing a risk to the Canadian economy. And the G-20 is really focused on fiscal restraint as opposed to supporting growth. That probably isn’t good for the growth currencies.”

Furthermore, there are implications for the Bank of Canada, which has already embarked on a tightening of monetary policy. It raised its benchmark interest rate – becoming the first industrialized economy Central Bank to do so – to .5% in June, and there is a 45% chance that it will do so again in July. The futures markets are currently pricing in a benchmark rate of 1.25% by year end. Ultimately, “The extent and timing of any additional withdrawal of monetary stimulus would depend on how the outlook for economic activity and inflation evolves.”

EUR USD 3 months 2010
The arguments in favor of the former are pretty strong. Namely, EUR/USD bearish sentiment had expanded to such an extreme level that a pullback – temporary or permanent – was basically inevitable. From this standpoint, what we have seen unfold over the last month-and-a-half is a classic short squeeze. Basically, those who were short the Euro were forced to cover their positions when it started to rally, which in turn triggered more selling, and ultimately, a self-fulfilling rally. As a result, “The difference in the number of wagers by hedge funds and other large speculators on a decline in the euro compared with those on a gain dropped to 38,909 on July 6, compared with record net shorts of 113,890 on May 11.”

Due to its sudden rise, the Euro became a much less attractive funding currency for carry traders. It helps that other Central Banks are delaying interest rate hikes, which means it’s difficult to turn a solid profit (on a risk-adjusted basis) from shorting the Euro. In addition, the markets have started to turn their attention to economic fundamentals in the US, which had been edging out the Euro in one of the perennially important rivalries in currency markets. In short, it suddenly became obvious to traders that the economic and fiscal conditions in the US are at best equal to those in the EU.

Finally, there was an implicit acknowledgement among the EU leadership that the so-called sovereign debt crisis is actually in many ways a banking crisis. This admission came in the form of stress-tests on 91 of the EU’s largest banks, designed to determine their exposure to sovereign debt and placate investors. After all, “It was German and French banks that led the way in lending to Greece or Spain.” This misjudgement has spurred such banks to set aside Billions in potential losses and vastly curtail their lending activities.

Unfortunately, investors are skeptical that the stress tests will be stringent enough, seeing them as a mere publicity stunt: “While the EU have tried to counter these suspicions by promising to publish the result of stress tests, the market is fearful that stress tests will force some banks into writing down losses on non-performing loans.” By extension, investors are still equally concerned about the possibility of a sovereign debt default, even one that it is only partial.

In other words, the consensus is that despite the EU’s best efforts to tackle the crisis, it still has yet to enact meaningful structural reforms, opting instead for short-term stopgap solutions. According to The Economist, “The debate about how to save Europe’s single currency from disintegration is stuck…because the euro zone’s dominant powers, France and Germany, agree on the need for greater harmonisation within the euro zone, but disagree about what to harmonise.” There remains a lack of agreement over whether the economically and fiscally weaker members of the EU will be allowed to remain members, and if so, what if anything will be done to keep them in line.

EU Public Debt

As you can see from the chart above, time is quickly running out. For the majority of EU countries, debt is now rising faster than GDP. From the standpoint of many investors, default seems like the most likely outcome since such countries lack the political muster to reduce their budget deficits, nor can they devalue their debt through currency depreciation, due to the common currency.

Thus, the consensus (for now) is that the Euro’s run will soon come to an end. According to Citigroup, “The euro will resume its decline and head toward the $1.10-$1.15 range. ‘The market has digested a lot of the bad news about the euro. There’s no great optimism.’ ” Meanwhile, BNP Paribas “expects the euro to fall to parity by the end of 2010—one euro per dollar—a level it hasn’t seen since December 2002…[and] drift to 97 cents before hitting bottom in the third quarter of 2011.”

Recently, gold prices have collapsed at virtually the same rate as the Euro, with the result being a near-record high short-term correlation between EUR/USD and gold prices. This has caused no shortage of confusion among gold-watchers, which are accustomed to seeing the strongest (inverse) correlation with the US Dollar. This change is causing everyone to rethink some classically held assumptions about gold prices.

Gold versus the EUR-USD
The foremost of which is that gold is chiefly a hedge against the Dollar, which is a symbol for inflation and erosion of value. [In fact, analysts argue that gold has little real purpose (besides a handful of trivial practical uses, such as jewelry), especially since holders of gold don't receive interest, there is little reason to own it other than as a store of value]. Thus, as the Dollar has declined over the last five years, gold has soared. Investors who are nervous about perennial budget deficits in the US and the skyrocketing national debt, have turned to Gold because of the belief it will continue to hold its value even (or especially) if the US government is forced to devalue its debt by devaluing the Dollar. While this tenet underlies the gold/Dollar inverse relationship, the long and short of it is that investors typically buy gold when the Dollar falls, and vice versa. Thus, when the credit crisis struck and the Dollar rallied, gold prices fell, despite the fact that the US was now more likely to default on its debt.

In the last month, however, the Euro has taken center stage in dictating the price of gold. This is most likely because of the sovereign debt problems of certain EU countries. A not insignificant number of which well exceed the budget (not to exceed 3% of GDP per year) and debt (not to exceed 60% of GDP) limitations imposed on them by their membership in the EU. Recent credit rating downgrades have underscored an increasing likelihood of default, which has been duly noted both by the forex and gold markets. As the Euro has dropped (quite dramatically in fact), so has gold.

According to the current paradigm, this is not wholly unsurprising, since the Euro’s fall has naturally been mirrored by a rise in the Dollar. Thus, if you continue to look at gold prices in terms of the Dollar, it seems naturally that a rising Dollar is being accompanied by falling gold. On the other hand, the fact that the Dollar is suddenly rising has little to do with a change in US fundamentals, and instead reflects the fact that in forex, it’s impossible to short all currencies simultaneously, even if sometimes fundamentals would justify such an approach.

In other words, that certain EU member states are more likely to default on their respective debt obligations has limited bearing on whether the US will also default. [If anything, it increases the likelihood, since a default in the EU would likely send sovereign borrowing costs higher around the world, straining the ability of the US to continue borrowing]. By extension, the current drop in the price of gold is fundamentally irrational, especially when viewed relative to currency markets. To borrow a hackneyed expression, perhaps it’s time for a paradigm shift.

When the news was announced, the Dollar plummeted by 2.7%, the highest daily margin since 1971, as traders mulled the inflationary implications of printing over $1 Trillion and injecting it directly into the money supply, with the potential of more to come. Wrote one analyst, “Interest rates now are effectively negative across the board. The dollar is selling off because this may contribute to long-term weakness in the currency.”
dollar-collapses

Unfortunately for the Fed and the Dollar, the last few weeks have witnessed a slight pickup in risk tolerance, as investors began to focus more on fundamentals. If this development took place in the deepest chasm of the credit crisis, investors might have been willing to look the other way, but now they are very concerned that a huge expansion of the US monetary supply could trigger long-term inflation. A less pessimistic way of looking at the Dollar sell-off would be to attribute it to investor confidence that the Fed plan will help revive the global economy, decreasing the appeal of the US as a safe haven for investing.

Whether this will push the Dollar down further towards the $1.40 range depends on a couple factors. First of all, will other Central Banks follow suit? “All the major central banks may end up in the same position. The way we look to play it is to see which goes the first and which one lags, and try to explore the timing difference between the two,” explained one analyst. If this proves to be the case, investors will once again focus on the “least worst” currency, in which case the Dollar could once again come out on top.

It also depends on whether this action is intended as a quick fix, or as part of a series of purchases by the Fed. “Sell the dollar!” said…a portfolio manager. “This is huge, huge. It’s equivalent to the Plaza accord. This is the last thing theyhave in the closet, and they used it a bit early.”
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On the one hand are the the Dollar bears, who point to an economic recession that continues to deepen, and the seeming complacency of the Federal Reserve Bank towards inflation. If there is any doubt as to how the forex markets feel about the Fed’s plan to purchase over $1 Trillion in US government bonds, consider that the the Dollar just recorded its worst weekly performance in 24 years, while the Euro simultaneously recorded its strongest week since its inception in 1999. There’s not much nuance there.

Meanwhile, the economic picture is equally depressing. Summarized by Kathy Lien of GFT Forex:

The Empire state manufacturing survey plunged to a record low in the month of March while Industrial production fell 1.4 percent, driving capacity utilization back to its record lows. Foreign investors reduced their holdings of U.S. assets by the largest amount since August 2007. Homebuilder confidence held near its record lows in the month of March as the slump in the real estate sector shows no signs of easing.

Unfortunately, there is a contradiction in the argument that the Dollar is being plagued both by economic collapse and by the risk of inflation. Writes Marc Chandler, head of FX strategy at Brown Brothers Harriman, “The pessimist camp wants it both ways. The US is going down the same path as Japan, where the end of a real estate bubble led to a banking crisis and a deep economic contraction. And they want to caution that printing of money will boost interest rates, fuel inflation and debase the currency.” He points out that history, as well as common sense, contradict this line of thinking.
Those that remain bullish on the Dollar argue that the Euro rally is a function of technical, rather than fundamental developments. First of all, we are approaching the end of a fiscal quarter. As evidenced by the Dollar decline which took place at the end of December, these periods are usually marked by portfolio rebalancing and hedging, such that it’s not uncommon to see large swings in forex markets. From a technical standpoint, when the Dollar failed to breach the $1.30 level against the Euro, many short sellers were probably forced to cover their positions, which accelerated the Dollar’s decline.

Bulls are confident that the pickup in risk-taking which catalyzed a 20% stock market rise is here to stay. “The move to the upside came after the government described a plan that will…generate $500 billion, and possibly $1 trillion over time, to buy hard-to-trade and badly deteriorated assets from banks.” The banks will be recapitalized, the financial system is being repaired, and everything will be okay, right?

The markets are certainly prone to false-starts. I can count numerous instances of government officials and market commentators insisting that “the worst is behind us.” Nevertheless, if this time proves to be different, it could be bearish for the Dollar, whose role as ’safe-haven’ currency would likely be eroded by a positive change in market sentiment.

While the Obama administration has pledged the kind of fiscal responsibility that would secure its government obligations, its actions haven’t been so responsible. The Fed recently announced purchases of $1 Trillion in government debt, while the government is set to rack up Trillion-Dollar deficits over the next decade, even by the most conservative estimates.

In other words, China is in a quandary; stop lending to the US, and you might see the value of your existing reserves plummet. Continue lending, and you risk the same result. Tired of participating in this apparent no-win situation, China is finally taking action.

First, it will petition the G20 at its upcoming meeting for some level of protection on its $1 Trillion+ “investment” in the US. Meanwhile, Zhou XiaoChuan, governor of the Central Bank of China, has authored a paper calling for a decline in the role that individual currencies play in international trade and finance. According to Mr. Zhou, “Most nations concentrate their assets in those reserve currencies [Dollar, Euro, Yen], which exaggerates the size of flows and makes financial systems overall more volatile.” His point is well-taken, since of the $4.5 Trillion in global foreign exchange reserves that can be identified, perhaps 85% are accounted for by Euros and Dollars alone. When crises occur, everyone flocks to these currencies.

Mr. Zhou’s proposal is not without precedent. “His idea is to expand the use of ’special drawing rights,’ or SDRs — a kind of synthetic currency created by the IMF in the 1960s. Its value is determined by a basket of major currencies. Originally, the SDR was intended to serve as a shared currency for international reserves, though that aspect never really got off the ground.” It’s not clear exactly how such a system would work, but the idea is straightforward enough; instead of holding individual currencies, which are inherently volatile, Central Banks would be able to denominate reserves in a sort of universal currency. Instead of parking money in US Treasury securities, they would hold IMF bonds, or some equivalent.

Even before China starting becoming more vocal about its concerns, analysts had begun questioning the role of the US as reserve currency. I’m not just talking about the perennial pessimists. Within the context of the current credit crisis, a bubble may be forming in the market for Treasury bonds. “Foreign buying of American financial assets by both private investors and governments averaged $141 billion from September to December, Treasury data show…Demand was so strong that, for the first time, investors accepted rates below 0 percent on three-month Treasury bills to safeguard their capital.”

There is concern that a slight recovery in risk appetite (of which there is already evidence) could ignite a massive sell-off: “People are sitting there holding massive amounts of zero- yielding dollar assets. If there is any sort of good news, demand for dollars can drop off very, very quickly.”

Regards,
The www.jolicloud.info team!

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