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Dollar Recovery: Real or Illusionary?

Note: This feature length cover story by Chris McMahon originally appeared in the April 2009 issue of Futures Magazine.
Dollar Recovery: Real or Illusionary?
Link to original @ Futures Magazine

With the U.S. dollar index trading in the low 70s through much of 2008, the Bush administration's so called 'strong dollar' policy had become a running joke. But the weak U.S. dollar served an important function, lubricating the global economy, and was one of the main propellants of the rise in commodity and equity prices. It took the bursting of the housing and credit bubbles and the resulting flight to quality to make the U.S. strong dollar policy real.

"Because people needed to raise cash immediately, they panicked and liquidated the only other asset they had: their investments. And for most people, 90% of that is stocks and bonds," explains Jason Alan Jankovsky, analyst and trader for Core Financial Group. "Now everyone thinks it's the end of the world financially and they are jamming money into cash assets, creating demand for dollars. But the fundamentals of the dollar are worse now than when it was making record lows." He argues that the effect of that panic selling has been an undervalued stock market and a temporary and artificial demand for dollars.

But even if the U.S. dollar is fundamentally weak, all the other currencies may be weaker and there are many traders who are bullish on the U.S. dollar longer term.

"The odds remain in favor of U.S. dollar strength, despite the fact that the fundamental picture remains pretty bleak for the U.S.," says Terri Belkas, currency strategist for "When you take into consideration how bad things look in other regions, like the euro zone, the UK and Japan, it's not quite as bad. You have to keep that in perspective." She says the most important factor determining U.S. dollar strength is increasing risk aversion (see "Risky business"), which favors continuing dollar strength.

"The giant global-macro theme that I see is global rebalancing," says Jack Crooks, CEO of Black Swan Capital Management. He says that the global economy is readjusting from over production by the surplus-side countries, such as China, and over consumption from the deficit-side countries, such as the United States. "We see that rebalancing process hurting China and the surplus countries more than it's going to hurt a country like the United States."

Debtor nation(s)

Conventional wisdom is that considering the immense increase in U.S. trade and budget deficits, China, Japan and other countries could lose their appetite for U.S. Treasuries, the sales of which are necessary to fund U.S. government operations and the expanding menu of bailouts and other interventions.

But the United States is not the only country bailing out financial institutions, offering stimulus packages and increasing debt issuance to pay for those efforts, observes Brian Dolan, chief currency strategist for "Everything will be fine with these debt issues until it's not fine and one of these Treasury auctions fails. We have had the last two 10-year German bund auctions fail; they did not attract as much demand as was on offer." On the other hand, struggling countries like Greece and Portugal have had successful 10-year auctions because of higher yields. "There is a trillion to a trillion-and-a-half dollars in U.S. debt being offered this year at a minimum. That's a lot and we are going to be watching very closely to make sure demand is there and at what price."

A high level of debt issuance has typically preceded inflationary periods or a devaluing of the currency, and considering President Barack Obama's unprecedented $3.6 trillion budget, many people are concerned about hyperinflation in the medium and long term, as evidenced in the rapid rise in the price of gold and other safe haven investments. And then there is the doomsday scenario in which China could stop adding to, or dump, its U.S. Treasury holdings, crushing the U.S. economy.

The argument is that with the breakdown of export markets, China could elect to spend on its own infrastructure needs, developing domestic consumption and managing rising unemployment. However, Crooks contends that's unlikely. "That's been the best damn investment they could have made. The dollar has gone up 25%. Treasuries have soared with risk aversion."

If the Chinese did sell, it would be a nightmare, but demand eventually would be replaced, he says, positing that the U.S. savings rate has typically risen during times of economic dislocations to between 6% and 8% of gross domestic product. Citing Goldman Sachs research, he expects the savings rate to approach 10% in the coming years. With U.S. GDP at roughly $13 trillion, that would eventually balance the $1.3 trillion in FX reserves in Asia. "You won't have massive over production in China and you won't have massive over consumption in the U.S. You will have more balanced global growth. If we survive, that's not a bad thing."

Despite the seven-year bear market (see "Long-term view") the world's reserve currency is still the dollar, Crooks says. "The penetration of dollar credit has actually increased. As the dollar starts to revalue, and it's already started, we will be over 70% held in U.S. dollars; so the dollar's status is not in jeopardy. Second, where else do you go? The pound is history, in this cycle at least." Further, he says the European monetary union could unwind due to widening bond spreads. "Portugal, Italy, Greece and Spain, they are fiscal basket cases. A few years ago, the spread between Portugal and Germany was maybe 20 basis points. Now it's 650 basis points. So that risk has to be priced in there."


Across the world, central banks have been cutting interest rates aggressively, and many have created bailout and stimulus plans. The notable exception is the European Central Bank (ECB), which has been reticent to lower interest rates. One reason is that the ECB is responsible only for managing inflation to below 2%. Promoting growth is the responsibility of 16 individual member nations.

"The euro experiment is the most significant financial event in financial history. It has accomplished something that people have tried to do for centuries, which is to unify them against the underlying reason people fight wars: money," Jankovsky says. The euro zone is the world's largest economy, and over months and years, he says it will replace the U.S. dollar as the world's reserve currency. "When you think about the economic powerhouse it represents, and consider that the world's reserve currency is under threat of devaluation, people will liquidate and diversify out of dollars and most likely into euros," he says.

But European banks had huge exposure to U.S. mortgage backed securities and now there is growing concern about exposure to emerging markets, where there has been $4.3 trillion of international bank lending, $3.7 trillion of which belongs to European banks compared with just $675 billion for U.S. banks, Crooks says.

"Take a look at Austria. They have the largest commitment in terms of the banking sector," Dolan says. "Those countries have borrowed heavily over the past decade. With the credit conditions we are seeing and the economic downturns in these economies, it's going to be difficult to roll over some of that debt." He says the euro zone is entering a deeper downturn than what the United States has already experienced because of the lack of fiscal stimulus and flexibility in the labor force and credit system. He expects the euro soon to trade between 115 and 118.

"The emerging market is starving for cash. The IMF has said they don't have enough money to keep them afloat if something else happens," Crooks says. "One more hit to the equity side, which is still a major collateral value for these emerging markets, and we think you are going to see some defaults," he says, naming Ukraine, Serbia, Hungary and Argentina as most likely to default, and noting that Ecuador already defaulted on a bond tranche. "That's the soft underbelly of the euro," he says. "Not that the United States has much going for it, but from a relative basis, it wins by default."


The British pound was the first major currency to break against the dollar because it was most leveraged against the financial services, Crooks says. "When the credit crunch hit, which was the game changer - no more derivatives production and more regulation - it hit them the hardest. And it's an inordinate hit because most of the discretionary income comes out of London and their consumers had even more debt than in the United States.

From a growth perspective, the British pound may be in the most dire position, Belkas says. "For a long time people thought London was the new financial capital of the world, but all that was built on a huge increase in leverage and all of these derivatives." With the collapse, job losses have been heavy and housing values have dropped significantly. "Everything related to finance has fallen apart," he says, and now exports, especially to the euro zone, have plummeted as well, which will hurt the trade balance and manufacturers.

Yen for value

During the flight to quality, the Japanese yen has maintained its value against the U.S. dollar better than most other currencies. This is due to Japan's persistently low interest rates and declining yield differentials as other central banks lowered rates to stimulate their economies. Those moves also prompted the unwinding of the yen carry trade, in which people borrowed yen to invest where returns are higher.

"The U.S. dollar and the Japanese yen have been trading hand in hand for a while, but ultimately we will see it lower, at around 90. We are at 94 right now," Belkas says. She adds that April will be a tumultuous time because of the number of earnings reports. "That will be a good barometer for how financial institutions are faring. If we do see that those banks are still accumulating a lot of losses,that could lead the Japanese yen crosses to trade lower."

The repatriation of Japanese assets has led to exporters now being over hedged, Dolan says, and that could end relatively soon. In addition to lower demand for consumer goods around the world, a stronger yen has made Japanese exports more expensive. As a result, Japan's annualized fourth quarter GDP was a staggeringly negative 12%. "Further yen buying from exporters is going to diminish. And as the global outlook begins to stabilize, asset managers, having just brought home all that money, are going to be looking for opportunities to send it back out." He says over the next three to six months, the USD/JPY should move to over 100.

According to Crooks, exports from Asia have fallen off by 30% to 40% and thousands of factories in China have closed. "Their official urban unemployment rate is 4.8%; unofficially it's 10%. They are still clinging to an official growth rate of 8% per year, but I bet it will come in under 5%."

What's next?

Jankovsky says investment will flow into Europe faster than it will flow into the United States, in part because of the interest rate differential. "If you could look at market opportunities and take currency risk out of it, where would you invest?" Jankovsky asks. "Nobody says the United States. I don't think the United States is going to lead the recovery; and money will go elsewhere as people diversify or divest themselves of dollars," he says. "I am trading dollars from the short side. You want to be selling rallies in the dollar."

Perversely, an economic recovery could be a triggering event for the U.S. dollar to reverse, as it would reduce demand for safe havens.

"If the stock markets bottom, that would weaken the dollar. They don't always go hand in hand," Belkas says. "When you take into consideration how bad things look in other regions, like the euro zone, the UK and Japan, it's not quite as bad. You have to keep that in perspective." She says that despite bleak fundamentals, odds favor continuing dollar strength.

"A winner in a deep recession/depression has to have a modicum of demand base. And we still have the best consumer base in the world, even though it doesn't have much to consume with right now," Crooks says. "You have to have flexible monetary and fiscal policy. We sure have that, they change it every day! Something will stick and eventually we will get it right. You have to have a capital-funding source. And we have the deepest capital markets in the world. You still have to have flexibility on the labor side, and we have that. From all those standpoints, and it's all relative, the U.S. wins that game."

Note: This feature length cover story originally appeared in the April 2009 issue of Futures Magazine.

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