Over the last month, the Dollar has rallied tremendously, rising over 7% against its main adversary, the Euro. The price of gold, which serves as an inverse proxy for investor confidence in the USD, has fallen dramatically. As a result, many analysts have proclaimed that the Dollar has (permanently) bottomed out, and are busying themselves preparing projections for how high the Dollar will rise. But is the Dollar rally sustainable?
In the short-term, I would argue the answer is yes. The bubbles in the various sectors of commodity markets seem to have partially deflated, with oil and certain food staples well below the record highs they touched earlier in the year. As a result, inflation may soon begin to abate, and return to a comfortable level as early as 2009. More importantly, the US economy was among the first to be affected by the credit and real estate crises. Some analysts have argued that the worst developments have already come to pass. The crisis has since spread to the global economy, with other countries sharing in some of the burden. The result is that the US economic and monetary cycle is probably ahead of most of its peers. Accordingly, by the time the full impact of the crisis is felt by the rest of the world, the US should firmly be on the path to recovery. As other Central Banks move to ease their respective monetary policies, the Fed should be in a position to hike rates, providing further support for the Dollar.
As a result of this belief, US capital markets have received a sudden inflow of capital. This trend has been further buoyed by the notion that the US is the safest place to invest in times of crisis is gaining traction among investors. If the credit crisis continues to spread, this notion will no doubt be reinforced.
The long-term picture is of course more nuanced. The US will hardly emerge from the current crisis unscathed, and the ultimate cost of the credit crisis could exceed $1 Trillion. In addition, the US is unlikely to be shamed into changing its nasty habit of spending more than it saves. Accordingly, the twin deficits, those permanent thorns in the side of the Dollar, will probably persist. In addition, recent history suggests that investors are slow to absorb the lesson that There is No Such Thing as a Free Lunch. Despite the horrible collapse of the dot-com bubble, investors piled willy-nilly into the real estate market, with the result speaking for itself. Analysts are already speculating where the next bubble will occur; perhaps in alternative energy?
In conclusion, while the near-term prospects of the Dollar are surprisingly bright, the long-term prognosis is less so. There is no indication that the structural weaknesses in the US economy that led to the credit crisis and the multi-year decline in the USD that preceded it, will abate following its resolution. The future is inherently unpredictable, but I would expect the Dollar to continue declining once the global economy is back on track, perhaps in 2010.
In the short-term, I would argue the answer is yes. The bubbles in the various sectors of commodity markets seem to have partially deflated, with oil and certain food staples well below the record highs they touched earlier in the year. As a result, inflation may soon begin to abate, and return to a comfortable level as early as 2009. More importantly, the US economy was among the first to be affected by the credit and real estate crises. Some analysts have argued that the worst developments have already come to pass. The crisis has since spread to the global economy, with other countries sharing in some of the burden. The result is that the US economic and monetary cycle is probably ahead of most of its peers. Accordingly, by the time the full impact of the crisis is felt by the rest of the world, the US should firmly be on the path to recovery. As other Central Banks move to ease their respective monetary policies, the Fed should be in a position to hike rates, providing further support for the Dollar.
As a result of this belief, US capital markets have received a sudden inflow of capital. This trend has been further buoyed by the notion that the US is the safest place to invest in times of crisis is gaining traction among investors. If the credit crisis continues to spread, this notion will no doubt be reinforced.
The long-term picture is of course more nuanced. The US will hardly emerge from the current crisis unscathed, and the ultimate cost of the credit crisis could exceed $1 Trillion. In addition, the US is unlikely to be shamed into changing its nasty habit of spending more than it saves. Accordingly, the twin deficits, those permanent thorns in the side of the Dollar, will probably persist. In addition, recent history suggests that investors are slow to absorb the lesson that There is No Such Thing as a Free Lunch. Despite the horrible collapse of the dot-com bubble, investors piled willy-nilly into the real estate market, with the result speaking for itself. Analysts are already speculating where the next bubble will occur; perhaps in alternative energy?
In conclusion, while the near-term prospects of the Dollar are surprisingly bright, the long-term prognosis is less so. There is no indication that the structural weaknesses in the US economy that led to the credit crisis and the multi-year decline in the USD that preceded it, will abate following its resolution. The future is inherently unpredictable, but I would expect the Dollar to continue declining once the global economy is back on track, perhaps in 2010.
Commentary: Anatomy of a Currency Trader
In the context of fundamental currency analysis, we usually talk about inflation, interest rates, economic growth, politics, etc. But perhaps these variables mask some deeper "truth" in forex, specifically that there is some ultimate "force" guiding the decision-making processes of forex traders. What we are really talking about here is comfort with risk. Especially in the medium-term (the short-term consisting of hours and defined by randomness and the long-term consisting of years and defined by relative changes in the money supply), investors are constantly re-evaluating the level of risk that they want to assume.
To make this idea more concrete, let’s look at how the credit crisis has impacted forex markets. In general, it has favored major currencies, such as the Dollar and the Euro, although sometimes one more than the other. This is to be expected since the capital markets of the US and the EU are the most stable and in times of uncertainty, investors seek out stability. Likewise, the Japanese Yen has fared well. Despite a continuation of its easy money policy, investors have unwound their Yen carry trade positions, ever-fearful that a spike in volatility could cost them dearly. On the other end of the equation are emerging market currencies and beneficiaries of the carry trade, which have faltered as investors pare their exposure to risk. The underlying narrative is the same; only now, investors are willing to accept lower returns in exchange for proportionately lower risk.
To make this idea more concrete, let’s look at how the credit crisis has impacted forex markets. In general, it has favored major currencies, such as the Dollar and the Euro, although sometimes one more than the other. This is to be expected since the capital markets of the US and the EU are the most stable and in times of uncertainty, investors seek out stability. Likewise, the Japanese Yen has fared well. Despite a continuation of its easy money policy, investors have unwound their Yen carry trade positions, ever-fearful that a spike in volatility could cost them dearly. On the other end of the equation are emerging market currencies and beneficiaries of the carry trade, which have faltered as investors pare their exposure to risk. The underlying narrative is the same; only now, investors are willing to accept lower returns in exchange for proportionately lower risk.
Commentary: The Dollar Conundrum
The Dollar is currently teetering on the edge of a precipice. Many analysts are predicting that, having recently retreated from a record low against the Euro, the Dollar’s best days are still in front of it. On the other hand, the economic data and interest rate pictures remain nuanced, and still favor the Euro on paper. In this article, we aim to sort through this morass, and produce a clear summation of the factors which bear on the Dollar in the short term.Let’s begin with the bullish side of the equation, which is supported by the Dollar’s recent upside swing. First of all, while interest rate differentials are currently hurting the Dollar, the Fed is probably near the end of its loosening cycle, while the ECB has yet to begin. The best-case scenario would be a tightening of US monetary policy simultaneous with a loosening of EU policy. Next, there is the economic picture. The most recent GDP data indicates an economy that is still growing, albeit slowly. In addition, the unemployment rate declined in the most recent month for which data is available. The US stock market has regained half the value it lost in the first three months of 2008, and the overall P/E ratio is close to its long-term average, which suggests the markets could appreciate further. Finally, the economic stimulus package that was approved by Congress in March will go into effect this month, as tax rebates worth $150 Billion are distributed to consumers and businesses.
On the bearish side, let’s return to the interest rate story. While the future certainly bodes well for the US, the present still favors the EU. US interest rates are currently negative in real terms, and investors have already turned the Dollar into a funding currency for carry trades. Moreover, negative real interest rates implies high inflation. US CPI is hovering around 4.0%, and could continue to climb in proportion with surging food and energy prices. In fact, inflation is now viewed by economists as more problematic than the economy, itself. While US exporters have benefited from the resulting cheap Dollar, US consumers- which account for 75% of the US economy- have not. The economic downturn still has not officially been labeled a recession by the Bureau of Economic Research, but the situation remains tenuous, and the scales could easily be tipped by a few pieces of negative economic data.
The wild card in this mess is housing. In certain regional markets, real estate prices have tumbled by 30%. In other markets, they have hardly budged. While an estimated $350 Billion in subprime debt has already been written down, analysts disagree over the eventual total. Estimates vary from $1 Trillion to less than $350 Billion, which would imply "write-ups" on debt that was erroneously declared worthless. The difference represented here amounts to 6% of GDP, which could mean the difference between growth and contraction, a strong Dollar and a weak Dollar, respectively.
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