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Tuesday, August 12, 2008

Is the Buck Back?

By Claus Vistesen Copenhagen

CAN you feel it? That cold empty void that should have been Macro Man's dissection of last week's flight of the buck. Of course, this only goes to show that our good MM's initial hunch was right in the sense that when he sets off on holiday fireworks spark from the sky in market land. Last week consequently marked the biggest USD rally (against the Euro) since the conception of the single currency. Actually, last week had the buck written all over it as Uncle Sam's currency rose against almost anything that moved to erase everything but a small part of the loss it had sustained so far in H01 2008. It seems that the exercise of leafing through those Benjamin Franklins is not as pityful an endeavor as it used to be, only a few months ago.

Of course, the past week's performance of the USD is of such a magnitude that many FX punters and analysts are expressing caution as to how much further traders can expect it to go on.

Bloomberg consequently serves up a nice batch of conflicting analyses from the currency desks of the world's investment banks and other money movers. A lot of interesting points can be derived from the piece, but the main message for now seems to be that if you did not manage to catch a ticket to the ride last week, the current level does not seem to offer more juice.

Stefan Karlsson suggests that the past week's move is nothing but a sucker rally which I am sure that anyone having the forsight or luck to buy some USD - leverage style - last monday would happily accept as they buy back their positions today. More specifically he also suggests that now would be a good time to shed any remaining dollar denominated assets due to the obvious relative valuation advantage. Clearly, the thrust of the rally cannot be expected to endure but I feel confident that the relative weakness of other regions and economies could mean that the USD will a find a new higher level. This would apply, in particular, against the Euro, the Kiwi, the Aussie, and the JPY. In this light, I am latching on to Stephen Jen's and Luca Bindelli's general point as expressed here that the rest of the world is finally re-coupling to the US slowdown. It is important here to understand the nature of re-coupling and de-coupling. The main point here would be that the economies of the world who are dependent on exports and foreing income to grow cannot, on the basis of simple logic, decouple from a slowdown which cuts laterally through the economies of the world with substantial external deficits. In this spectrum, the US has already taken its share of the beating and now fellow deficit nations will need to make a similar choice. If interest rates are kept high there is plenty of excess savings to go around which in turn will make sure that the purchasing power of the currency stays high. But it is wise to follow the Fed's lead down?

In this context, I think that the following point made by Morgan Stanley's Sophia Drossos (quoted by Bloomberg) represents a good example of the issue at hand.

That means investors will continue to suffer inflation-adjusted returns that are negative based on the current annual consumer price index of 5 percent and Treasury securities yielding between 1.695 percent for three-month bills and 4.53 percent for 30-year bonds.

This has to be one of the most significant deterrents in the context of buying USD denominated assets. However, it also suggests that those who are more than willing to finance the external US deficit with a nominal yield below inflation, are not buying those bonds because of the current return (segmentation theory anyone?). Actually, one could argue that the US, by submitting its creditors to this treatment, is trying to release itself from the yoke of global consumer of last resort. For a time it seemed as if the Euro could take up the baton but this was obviously always going to be a tosh. The Eurozone is likely to have entered a recession in Q2 and going into Q3, but the simple point is that the Eurozone is extremely fragile. At this point the ECB's hawkish tone on inflation carries a distinctly hollow tune with Spain and Italy in the ropes and an export dependent Germany whose main customers in the form of its fellow Eurozone bretheren, and the CEE economies, are heading for serious corrections.

Another mitigating effect on the USD would be the recent drop in Oil prices which, coupled with a stronger USD, seem certain to improve the overall trade balance. Furthermore, if the oil related deficit is set to fall it will also lay bare the improvements made in the context of the non-oil deficit since 2006. Before you get your hopes up though, I would reiterate Felix Salmon in pointing out how FT's Krishna Guha is a must read this week. Especially the following point also highlighted by Felix;

At today's prices the value of oil in the ground exceeds the combined value of all the world's equity and debt markets. Oil-importing nations are paying oil-exporting nations roughly $1,500bn per annum for oil - about 2.5 per cent of global gross domestic product - by some measures the biggest income transfer in history.

And then Felix' reasoning on the basis of Guha's argument;

Yes, the savings rates of oil exporters might start falling as their capacity for domestic investment rises. But there's no doubt that their savings in absolute terms will rise impressively for the foreseeable future. If you think the SWFs are big now, just wait another decade: they'll have major geopolitical importance then.
The last two waves of petrodollar investment both turned very sour in the end, and I can't say that the medium-term outlook is any better. The magic of capital markets is that they're meant to somehow take capital from investors and funnel it to where it can be put to best use in the real world. But with banks deleveraging and investors staying risk averse, it's not easy to see that happening with any elegance in the future.

This is an extraordinarily important point in my opinion, since what Felix essentially latches on to is the fact that excess liquidity is a structural global phenomenon, not necessarily because of evil doings by Greenspan and Bernanke, but because of too much capital chasing too little yield. Ok, I might be putting Felix' good name on to more than he would like, but it is important to understand these dynamics. The current crisis will only serve to exacerbate the structural trend of more money chasing yield, since the main fault line of the crisis cuts across economies who are net absorbers of global capacity (i.e. the external deficit nations!)

I agree in this regard that lowering interest rates to serve up negative real interest rates for one's creditors is a dangerous strategy indeed; especially with the funding need the US has. However, it is also, I think, a deliberate attempt to free the US economy from the role as global consumer of last resort.

But what does all this have to do with USD then?

Well, there are two important points here.

1. I think that there is good reason to expect the USD to move for a higher level against a number of key currencies. I would note the Kiwi and the Aussie in particular here as the two most recent external deficit nations who have succumbed to a slowdown. By consequence, the respective central banks are now beginning to prepare markets for potential rate cuts (the RBNZ has already moved in to trim rates). I would also mention the Euro here since the violent movement of the EUR/USD in the past year has been pinned on a hope and belief that the Euro would somehow take over the USD's role and obligations in the global economy. This is obviously not going to be case and as such, I believe it to be quite in line with fundamentals that the EUR/USD is drifiting lower. However, there is also a floor for the USD's potential descend here since the interest rate differential is likely to stay in favor of the Euro for the forseeable future. Whether the Euro will stay strong, in historical terms, against the USD will also depend on the nature of the incoming slowdown. I see considerable downside with respect to the events unfolding in the Eurozone, which also ultimately translates into further downside for the Euro. An important point to watch in this regard will be the extent to which the Euro manages to claw back the past weeks' sharp drop. In short; are we seeing the EUR/USD establish a new level here or will it scoot back to its hitherto maintained 1.54-1.56 band?

2. Then there is the much wider question of global imbalances and what role the US economy should (and indeed is willing to) assume in the global economy. Hardly anyone with but a faint whiff of economic wit would disagree in the fundamental impetus for the USD to fall. Whopping twin deficits, a sharp drop in nominal yield advantage, and a incoming recession are all factors to suggest that the USD should be in for a beating (and beaten it most certainly has). Yet, the US deficit cannot suddenly dissapear without a subsequent reduction in its creditors' surplus or an increase in other nations' deficit. I do think that most will agree here. And this is where the mechanics of the global economy, and I have to say some analysts reasoning, begin to falter. Because, who will be willing and indeed capable to suck up the excess global liquidity? Sure, India, Turkey, Brazil et al will do their part but it is not going to be enough, that is for sure. Meanwhile, and as I have pointed out before, not only mercantilist emerging markets are to blame here. So is the great demographic transition which is sweeping our planet at this very point in time, and on whose end point we can only guess

In a US context, the policy choice is furthermore complicated by the large composition of oil in the external deficit. The point here would be that a strenghtening of the USD would actually reduce the oil deficit in the sense that it makes commodity imports (denomimated in USD) cheaper [1]. This of course, would bring another part of the equation into the spotlight in the sense of the ties to China and her ever growing exports. In a more general light, one could also easily argue that the last thing the US needs at the present time, is for an increase in purchasing power to potentially prolong a show featuring a consumption binge, which has been on the showcase for way too long.

Thus, it seems as if re-balancing is slowly moving forward as per reference to today's news that the US trade deficit improved in june as exports rose 4.1% [2]. Clearly, the recent week's theatricals in the FX markets have little to do with this and even if the USD finds a new level e.g. against at the Euro at around 1.40 it would still be weak in historical terms. This also applies for the current levels of the AUD and NZD as well as to JPY where we would need to see 120-130 before reaching pre-credit turmoil levels.

Ultimately though, long term fundamentals in the global economy are much more than standard textbook theories of inflation and external balance driven currencies. It is also about demographics, a subsequent hunt for yield and investment capacity as well as a mixture of floating and fixed exchange rate regimes. In this context, the USD still needs to weaken (or stay weak), but the relative level and duration of this weakness may not be as unambiguous as many would have you believe.


[1] Although of course, it is never as simple as it looks. See Econbrowser for good discussion on this and the relationship between the USD and oil.

[2] Of course, there is a negative demand effect here to as the US consumer is simply not spending as vigorously anymore