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Dollar Perspective...Some Lists

Dollar Perspective...Some Lists

It is no mystery that I have been a dollar bear through much of the last two years (no not from the highs of 2002, but not far from them). Why am I still bearish? Especially why after issuing a buy recommendation several months back at 1.27 in the euro? Stubborn? Misled? Misunderstood? Wrong? None of the above. I believe...is all. Markets are not subject to scientific laws entirely and maybe not mainly. They (valuations) exist as a collective expression of the beliefs of participants. And in the current quarter of an infinite match or game, the collective whole is pretty divided in its beliefs. An insufficient number feel committed to a lower or higher dollar, while the majority are noncommittal. It smacks of a reasonable equilibrium. Euro/dollar at 1.20-1.24 is more or less a level where markets see fair valuation. Equally one could argue that dollar/yen has found an equilibrium range in the 105-115 area. There is no case right now for a major miss-pricing in these two major exchange rates. Hence it makes sense to trade the range until conditions change sufficiently to shift collective psychology. Equilibriums are temporal. Today's fair value can quickly be tomorrow's miss-pricing. Which brings me to two more questions - what conditions can change and why do they favor a weaker dollar...eventually?

I have two lists of reasons. The first is a list of reasons that can't be predicted but provide an ongoing vulnerability and will not be evident until it is underway. In other words the US current account deficit on its current track of growth is unsustainable...this is an axiom, but nothing that one can trade on until it happens...like an asset bubble. The second is a list of reasons that are quite evident now and argue for a move soon through the lower end of the dollar's range. These are real and immediate factors. Oh and just so you know I have weighed out the positives as well as the negatives there is a third list of what I think is currently supporting the dollar.

The Really Big Things List

1) It's the current account stupid. Yes the deficit is unsustainable and running north of 5% of GDP and growing. As Larry Summers, former Treasury Secretary and President of Harvard University wrote in the recent issue of Foreign Policy, http://www.foreignpolicy.com/story/cms.php?story_id=2581, this is a savings crisis (US does not save) and foreign investors are funding more than simply government spending via guaranteed IOU's...they are funding US mortgages, unsecured credit and corporate borrowing from unrated to highly rated paper. Summers, who may be the next Fed Chairman, states the case as well as anyone.

2) The US housing market has bubble qualities to it...namely regional bubbles and they are unsustainable. This condition is a fallout of ultra accommodative monetary policy, demographics and more recently an under performing stock market. Low mortgage rates and rising home prices have been a key catalyst driving US consumption since the Fed relaxed policy in the face of the 2001 recession. Asset bubbles are difficult to identify, quoting Greenspan, and even more difficult to predict when they burst.

3) The credit market bubble...highly leveraged households and firms...natural outcome from unnaturally low rates over an extended period of time. There is plenty of official talk about how well the risk in this market has been diversified. I am less convinced. Credit derivatives are not without risk, lack price transparency and have been the single largest transformation in the financial markets in a decade.

4) The US budget deficit...$445bln deficit this year (CBO) and heading for a massive explosion in 7-10 years time when baby boomers retire. Costly security outlays, rising health care expenses for retired (Medicare) and higher debt service in rising rate environment pose huge risks to the US budget deficit. Wishful thinking over high growth rates closing the gap is allowing most to ignore the problem. Truth here is massive tax hikes (including closing corporate tax loopholes) and massive reform of entitlement programs (spending cuts) are in the future with few politicians willing to own up to this. In the interim the gaping budget deficit risks crowding out private investment (more of a problem when interest rates are normalized) and contributes to the current account deficit (more foreign claims on US assets).


The Here and Now List.

1) The US economy is slowing...yes it is more than a slow patch. Oil, terror, US politics, overextended consumer (borrowed and spent out), fading fiscal stimulus and restrained firms reluctant to invest in new capacity, all point to a sharp slowing in the US economy.

2) Sagging US stock market. Sure this is matched by most stock markets globally, but with low US savings, to some extent US stock prices like any US asset depend on foreign investment flow to support prices. And weak US stock prices contribute detrimentally to firm and household sentiment...negative wealth effect.

3) Declining US productivity growth rate (return to historical norm...2.5-3.0%). High US productivity rates have been a key ingredient in making the US a destination for global savings...implies higher rates of return. Indeed some argue that the US c/a deficit is a function of desire of foreigners to invest in the US rather than US going to the world hat in hand for investment. But this is just an identity (capital account surplus equals the current account deficit) and not material to risks associated with adjustment shocks. Yet if US productivity is slowing and the rest of the world's productivity rate is more or less unchanged, then the dollarn will weaken as fewer foreign investors put their savings to work in the US.

4) The Fed may hit neutrality a lot sooner than many first thought as the US economy risks stalling. Moreover, the more the Fed is in denial over this and the more it hikes, the greater the risk of a stalling. It is also conceivable that long rates rise if foreign investment flows into the US decline, though not a here and now risk. So Fed tightening could be a shorter-lived prop for the dollar.

The Dollar Positives List.

1) US productivity growth rate is still quite high relative to major trading partners.

2) The Fed is tightening and the economy is growing at a healthy clip.

3) US capital markets are the most liquid...supply, transparency, liquidity and efficiency are all here and less so elsewhere.

4) The dollar is the world's main reserve currency and likely to stay so and despite what is written about foreign central banks diversifying, most are content holding the vast bulk of their reserves in dollars.

5) The love affair with Asia growth and hence assets is cooling...one fewer alternative destination for capital.

6) Europe's economy is structurally handicapped and despite government desires and pressure from capital markets, the people of Europe like it the way it is...the favorable labor and pension laws, primarily. The higher euro/dollar view is not about a rush to invest in the Euro Zone on the expectation of higher rates of return over time. It is all about things going wrong with the US and European investors sending less new cash to the US, ceasing sending cash or in the worst case pulling out. The dollar benefits from a euro and for that matter yen handicap.


David Gilmore
FXA
www.fxa.com

 

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