Whither Dollar?

Tracing Uncharted Territory This is an acceleration of the trend seen upto now, of Dollar depreciation across the Board. Date = Above is the chart of the Dollar’s combined value across all trade-weighted currencies (the Real Effective Exchange Rate, REER of the Dollar), which has hit historical lows. The obverse of this is the value of Gold: A look at the Gold chart will tell you that the rally is not finished; in fact, it could be entering its “irrational phase”. That is to say, the current worldwide ‘consensus of Dollar Depreciation’, can see a situation of everyone entering into one-way trades, selling the Dollar and buying SOMETHING ELSE. The overall theme will be a flight from the Dollar, into other currencies, commodities, assets. The fundamental reason for this is that there is a huge increase in the supply of Dollars (easy money policy of the Fed), a low Fed rate of 0.25%, a clear communication from the Fed that they will HOLD low rates for at least 6 months. In short, a Guarantee from the Fed that one side of the carry trade is predictable (i.e. you can borrow in USD at <0.5% for the next 6 months). Now where is the money going? The Aussie Dollar has seen an interest rate hike by 0.25%, a clearly AUD positive move, which will drive incremental flows into the AUD. The natural flows from any Dollar selling will go into the Euro (long-term average of 63%), so any Dollar depreciation should be reflected 63% into the Euro. THAT IS NOT THE CASE, just now, and that is very significant. It means the flows out of the Dollar are veering round to other (minor) currencies like the AUD, INR, etc. We can see that the Rupee has moved dramatically in the recent past, breaking the 48 bottom very sharply, while the Euro has yet to break its earlier top of 1.48. NOTE: the Dollar has turned into the money supplier of the world, a position hitherto reserved for the JPY. We already know that Japanese savings have collapsed, and this is expected to be a long-term trend. Japan’s population is expected to tip over into a post-retirement ‘dis-savings’ age, when they start to draw on their savings. This is expected to push Japanese Govt debt to 240% of GDP by 2014, above the bankruptcy line. In short, we can ignore the JPY as a source of the carry trade in future. How do you think all this is happening? US Stimulus money (TARP funds) are fed into Citibank, which starts to ‘lend’ out to safe businesses. Since nobody has any appetite for any risk-taking any more, these ‘businesses’ park the money into a European bank, denominated in Euro deposits, say, with RBS. So now, they have sold the Dollar and bought the Euro, and are getting a good yield on their Euro deposits, besides the 15% currency appreciation in Euro: USD in recent times. RBS has no business any more, and doesn’t want to lend anyway. So, believe it or not, they are buying Citibank CDs, simply because the Reserve requirements on TARP-fed banks is now lower in many European countries. All this counts as ‘business’ in both countries and the money returns to Citibank, to start its circular journey all over again. Just imagine what will happen when the Fed decides to hike interest rates and this ‘carry trade’ unwinds. In the old Japan-funded carry trades, the money used to go back to savings-surplus Japanese investors, who just had to park it somewhere. So you had this build-up of carry-trading, followed by small bubble collapses, temporary runs on various borrowing currencies like AUD, NZD, SAR, CAD, etc. But the money would return, and the party would reflate all over again. This time, however, whenever the US Govt pulls the plug on the TARP funds and ‘books profit’, the funds will have to be returned for good. And maybe the second wave of the Great Depression of 2008 will start…. On the one hand, the US Fed has offered its own ‘moral hazard’ to bond traders, by promising to keep the Fed Funds Rate unchanged at current levels. Even the great Paul Krugman has put his weight behind this policy, saying clearly that with inflation well under control (because it has been exported through the carry trade), there is no way the US should bring down rates till unemployment starts to fall from its currently horrendous 9.8%. He recommends holding down rates for 2 years; just saying it will create expectations that will push the Dollar Index (DXY) down below its historic low levels of 76 just now. And that is a self-fulfilling prophecy. Krugman argues that this is good for US exporters and points to the falling Current Account deficit, now down to about $250 bn. All very good for the US, but do consider how the imbalance is building up on the other side. I argued in a previous article that US demand for the world’s savings was falling off a cliff, and the old imbalances were correcting spectacularly. Structurally, I had argued that if the US turns into a Clean Energy supplier, it would bring back huge value to the Dollar, completely upsetting the current consensus. The fundamentals may or may not change, but technically, who would have thought that the world would be carrying trading against the Dollar? US Stimulus liquidity is now supplying speculative positions in emerging markets and high-yielding currencies, with talk about Gold doubling from these levels. If all this happens, we could see the DXY Index at below 60; few realise it, but the Dollar is in territory similar to where the stock market was in Oct- Nov, 2008; and we know what happened to those sellers. I don’t know the bottom for the Dollar, and I could be wrong by VERY LARGE margins, but I do know this for sure. If you look at the Gold-Dollar chart, the area between the 2 curves is already at a 30-year high, beating the 1985 spike to $850 during the Iran crisis. Either you now believe that the USD will never come back; there is nothing in the current flow of news to suggest that; I would rather say that for Europe than for the US. Or something is wrong somewhere; I am still a cautious Gold bull, but the relative movements with the Euro/ JPY would suggest that the Dollar looks the strongest of the 3 big currencies on current fundamentals. Sell JPY, buy Gold might be the trade of the decade!!! Or if you have the stomach, sell JPY, buy Dollar with the ability to ride out a huge downside… Sanjeev Pandiya teaches, trades and writes. spandiya@hotmail.com.