Monday, October 19, 2009

The contrarian views on the dollar

If you were to ask market participants about the dollar, its direction, and its place as the reserve currency, here is a typical answer you would get:

PIMCO: As the global economy recovers, it is likely that the 2008 surge in the net U.S. international liabilities will put downward pressure on the dollar for some time to come. In a post-crisis world the relative attractiveness of U.S. assets has and will likely continue to decline, and global investors may seek to rebalance away from the 60% increase in their net exposure to U.S. assets that occurred in 2008. This is negative for the dollar and, in the New Normal, also likely negative for the relative performance of U.S. equities, especially for companies without a global presence that must grind out profits in a world of 4% nominal GDP growth.

This is the standard, well accepted doctrine these days, particularly as the dollar continues on it's downward path. But if one digs a bit deeper, the level of certainty about continued dollar weakness becomes less pronounced.

With the dollar paying nearly nothing, it makes it a great candidate for the carry trade. Shorting the dollar is becoming everyone's favorite pastime (including retail investors). That trade is however quite vulnerable to rate increases.

Some folks from Barclays published a paper (see attached) that argues that dollar will strengthen next year as US rates increase. The chart below shows that in spite of record fixed income issuance in the US (particularly treasuries), the Fed has absorbed a large portion of that new paper. This low net supply resulted in continuing demand for US fixed income product, keeping rates low and dollar weak (in addition to the Fed keeping overnight rates near zero).

As the Fed slows down it's purchases next year, Barclays argues that the net supply of fixed income paper will rise sharply (chart above) putting upward pressure on rates. This in turn will reduce the dollar's appeal as the base currency for the carry trade (borrowing dollars will no longer be "free"). That may in turn stabilize the dollar (particularly a sharp carry unwind).

In fact some are becoming quite impatient with the Fed's slow response, arguing that near-zero rates foster asset bubbles:

Andrew Bary (BARRON'S, Oct 19th): IT'S TIME FOR THE FEDERAL RESERVE TO STOP talking about an "exit strategy" and to start implementing one.

There's no need for short-term rates to remain near zero now that the economy is recovering. The call to action is clear: Gold, oil and other commodities are rising, the dollar is falling and the stock market is surging. The move in the Dow Jones industrial average above 10,000 last week underscores the renewed health of the markets. Super-low short rates are fueling financial speculation, angering our economic partners and foreign creditors, and potentially stoking inflation.

The Fed doesn't seem to be distinguishing between normal accommodative monetary policy and crisis accommodative policy. There's a huge difference.

But what about the argument that the dollar will be soon replaced as the primary reserve currency as well as the primary currency for settling financial transactions (such as sovereign CDS for example)? Ed Grebeck (CEO of Tempus Advisors) argues (in an e-mail) that choices for alternatives continue to be limited:
* Euro ? - just another fiat currency, like the dollar, but worse: backed by 800,000 Brussels bureaucrats. It's not a "real" economy and putative political will.
* Yen ? -- neither the Japanese nor world are comfortable with Yen as reserve currency.
* "Exotic" currencies ? -- [Australian, Canadian, New Zealand $, Scandinavian, etc], too small.
* BRIC currencies ? -- illiquid markets and carry political risk... anyone trust Russia ? Brazil and hyperinflation history ? ... perhaps some decades/generations ahead after political issues resolved, China and/or ... India ?
* Sterling and Swiss Franc -- before they were "big" alternatives to USD, DEM, but now "too small" relative to USD and Euro.

So before plowing wholeheartedly into that short dollar trade, just remember that it sometimes pays to be a contrarian.

US Dollar Forecast
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