Commentary

Despite its multi-year decline, the US Dollar remains the
world’s undisputed reserve currency, claiming a 65% share of total Central Bank
reserves. However, the chorus of soothsayers
proclaiming the apocalypse for the Greenback is growing louder by the day. Every week seems to offer a new piece of news
confirming that the Dollar’s reign is coming to an end. Analysts are drawing parallels between the
British Pound of 50 years ago and the Dollar today. China is threatening to diversify
its reserves into Euros. Iran and Venezuela are leading calls to
price oil in terms of a basket of currencies, rather than in USD. The other members of OPEC are considering
de-pegging their respective currencies from the Dollar. What does all of this mean? Is the Dollar truly in danger of being
replaced as the world’s reserve currency?

The short answer is ‘no.’ The US twin deficits have expanded
every year for the past decade and economic theory suggests that in order for a
nation’s current account to rebalance itself, a decline in the value of its
currency is required. At the same time,
these deficits are sustainable for as long as foreign investors, sovereign and
private, are willing to sustain them. And despite the looming threat of recession, economic data and anecdotal
stories suggests that such investors remain willing to lend their financial
support. For example, the announcement of record-breaking losses by American
financial institutions has been met with solid commitments to invest by
international investors.

In addition, while foreign exchange reserve diversification
is certainly justifiable from a risk management standpoint, it hardly makes
sense from a financial standpoint. The
case could have been made for foreign Central Banks to exchange their Dollars
for Euros and/or Pounds several years ago when both currencies were trading at
relative bargains to the USD. Now that
these currencies are more expensive, it seems harder for to justify buying
assets and securities denominated in them. Furthermore, Central Banks must recognize that diversifying now would be
counter-productive, by sending a wave of panic through the markets and
undermining their efforts. As one
analyst pointed out, Japan and China,
the two largest holders of USD, both have a vested interest in an expensive Dollar.

However, the long answer to the question posed at the beginning
of this article is closer to ‘maybe’ than ‘no.’  In the long-term, Central Banks will certainly
move towards a more diversified portfolio of currencies.  For countries like China and Japan,
this will help minimize risk.  For countries
in the Middle East that peg their currencies to the Dollar, this will enable them
to conduct monetary policy independent of the US.  Ultimately, US capital markets are the most stable
and liquid in the world, and regardless of the value of the USD, it will serve the
interests of Central Banks to denominate a large portion of their portfolios in
Dollars.  Besides, analysts can be
extremely fickle. It was only five years
ago that the Euro was trading below parity with the USD and analysts were predicting
its collapse.  The fundamentals underlying
both currencies have not changed much since then, yet commentators have
reversed their positions. Who knows what
such analysts will be preaching five years from now…

Original post by Jimmy Atkinson and software by Elliott Back

Now that the furor over the US housing crisis/credit crunch has
begun to subside in forex markets, investors have turned their attention to
what is perhaps the second biggest threat to the Dollar’s long term health: the
PetroDollar phenomenon.  In short, the
price oil is denominated in Dollars and many oil-exporting nations peg their
currencies to the USD. Having found
themselves awash in cash, such nations are beginning to ponder greater financial
independence from the declining Dollar.

The anecdotal evidence for the declining importance of the
Dollar among oil-exporting countries could not be stronger. Last week, the Forex Blog reported two developments. First, OPEC is considering
altering the way oil contracts are settled, by pricing oil in a basket of
currencies rather than in USD.  Next, the
members of the Gulf Coast Council are considering de-pegging their currencies
from the Dollar, due to rising inflation and the increasing opportunity cost of
owning Dollar-denominated assets.

Actual data, on the other hand, suggests that OPEC may be moving
in the opposite direction, towards a greater dependence on the Dollar.  The US remains the most popular
destination for petrodollar investments, attracting 55% of all such investment
capital. Europe comes in at a distant second, attracting just 18%. Plus, in the last year, oil money has been
used to make several widely-publicized investments in American investment
groups, including a recent $7.5 Billion investment in Citigroup by the Abu
Dhabi Investment Authority.

The evidence is certainly nuanced. In all likelihood, OPEC will make good on Iran’s failed
attempt to sell oil denominated in Euros by linking oil to a basket of
currencies.  In their own words, “oil is
being sold in a currency whose value was eroding by the day.”  At the same time, the US is still the
home of the world’s best capital markets, from the standpoint of stability and
risk. Thus, while it’s possible that some or all of the members of the GCC will
de-peg their currencies from the Dollar, any relative decrease in
Dollar-denominated investments is likely to be passive, rather than active. 

Original post by Jimmy Atkinson and software by Elliott Back

At last week’s G8 meeting in Washington, it was expected that currencies would be a hot topic of discussion.  With the Dollar retreating to record lows on a daily basis, the failure of China to allow the Yuan to appreciate, the Japanese Yen’s continued weakness despite its strong economy, and the recent parity of the Canadian Dollar and USD, there are certainly plenty of forex phenomena that deserve attention.  However, it is the Euro/USD relationship that probably received the most scrutiny, as the biggest contingent of the G8 uses the Euro.

European politicians and bureaucrats have spent the last few months arguing with America-as well as amongst themselves-over the declining Dollar.  The consensus is certainly that the Dollar is harming the European economies; as one German Minister phrased it, the “pain threshold” has been crossed.  At the same time, it is clear that a relatively weak Dollar is probably in the best interest of global economic stability, since the US current account and financial account imbalances can only be solved by changes in exchange rates.  Thus, there is a growing divide between European politicians, who tend to think in provincial terms, and the European Central Bank, which is more focused on the Big Picture.  The new President of France, for example, has been quite vocal in lamenting the appreciation of the Euro, even going so far as to demand the ECB step in.  Jean Claude Trichet, president of the ECB, responded by calling on European politicians to be circumspect in their comments on the Euro.

However, since Central Banks do not participate in G8 conferences, you can bet that politicians hounded Hank Paulson, US Secretary of the Treasury, on the declining Dollar.  Some analysts have even speculated that ‘intervention’ would enter into the discussions. In fact, the US has not intervened in forex markets since 1994, when Europe and American worked in tandem to prop up a then-ailing Dollar.  After a couple months, however, the plan was abandoned due to mixed results.  Is it possible that the US, confronted with the same situation, will once again attempt intervention?

The answer is “not likely.”  First, the Europeans are not even united in their position on the USD/Euro exchange rate.  Secretly, they would probably all prefer a stronger Dollar, but in public, only a handful have called for intervention.  Second, short of fixing the exchange rate (which would require the US to borrow money), it is very difficult for a government/central bank to control its currency.  Recent intervention by South Korea and Japan, as well as America’s efforts in 1994, ended in failure. Finally, there is the issue of China, which does control its currency.  The US would surely appear hypocritical if it intervened on behalf of the Dollar while simultaneously encouraging China to float the Yuan.  Thus, while certain US economic concessions may result of the G8 conference, a controlled appreciation of the Dollar will not likely be one of them.

Original post by Jimmy Atkinson and software by Elliott Back

When the US Dollar eclipsed its previous record low against
the Euro last week, commentators immediately began painting doomsday scenarios
for the beleaguered currency. On paper, the argument for a continued decline in
the Dollar is quite strong, due to a sagging economy, surging current account
deficit, the prospect of lower interest rates and turmoil in US capital
markets. But, in practice, the Dollar remains the world’s de facto reserve
currency, which begs the question: “how much-if at all-will the Dollar decline?”

Let’s begin by examining the state of the US economy.  At this point, economists have clearly
identified the housing/real estate sector as a major weakness in the US economy.  Instability and an overall lack of demand have
contributed to falling prices for real estate, which is eating into consumers’
disposable income, and hence threatens to bring down the rest of the economy.  In fact, the most recent employment data, which
has become the most-watched piece of economic data in recent years, signaled
that for the last 3 months, no new jobs were created in America, which
is a tremendous cause for concern.

As a result, it is all but certain that the Federal Reserve
Bank will lower its benchmark interest rate at its next meeting, perhaps by as
much as 50 basis points.  While this may
soften the impact of the sagging housing market on the rest of the economy, it
will also decrease the EU-US interest rate differential to only 75 basis
points. In addition, the European
Central Bank will likely raise rates at its next meeting, which means the
differential will be further reduced.  Combined
with general instability in US capital markets, brought on by weakness in
mortgage-backed securities, foreigners are beginning to grow wary of investing
in the US.
While a US economic recession would decrease imports and perhaps stem the growing trade
imbalance, foreigners may still decide that it is too risky to continue financing
the US trade deficit.

On the other hand, many Dollar bulls insist (correctly) that
the Dollar remains the world’s reserve currency, and serves as a safe haven in
times of global economic instability.  And
in fact, the Dollar initially appreciated in value despite the turmoil in its
securities markets. However, this upward
trend seems to have been the result of a temporary shunning of risk, and since
then, the Dollar has resumed its fall.  In
short, both in theory and in practice, the evidence suggests that the Greenback
can still fall much further against the world’s major currencies.

Original post by Jimmy Atkinson and software by Elliott Back

Most commentators assume that the only thing currently
keeping the USD afloat is high interest rates. While attractive rates have certainly encouraged an inflow of (risk-averse)
foreign capital in the short term, they may ultimately be harming the currency in the
long-term. In fact, the economic law of interest
rate parity dictates that currencies and interest rates should move away from
each other in the long term. Stated
differently, high interest rates should imply a less valuable currency. Since US rates are among the highest in the world, the USD should decline in the long term in order to compensate US investors in foreign securities for the lower risk-free returns they are implicitly accepting.

The reasoning is simple enough: since the advent of currency
futures, traders have been able to speculate on future exchange rates. In order for futures to be priced fairly
(such that arbitrage is impossible) the difference between a currency’s current
value and its implied future value should perfectly equal the difference
between domestic interest rate levels and international interest rate
levels. In the case of the US, bets on
the USD made during the recent period that US interest rates have exceeded European
and British interest rates, must have been predicated on a declining USD in the future,
which is now the present.

Original post by Jimmy Atkinson and software by Elliott Back

As 2007 draws to a close, the Forex Blog would like to formally deliver its second annual ’state of the markets’ address. While the picture in most capital markets was blurry and nuanced, the story for forex markets was relatively straightforward. Simply speaking, the story was all about the US Dollar, which followed up its worst year in recent memory in 2006 with an equally abysmal performance in 2007. In fact, over the last two years, the Dollar has fallen over 20% against the Euro, and even further against most of the world’s other important currencies.

During the early part of the year, evidence mounted that the current US economic cycle had peaked, and analysts began to speculate that the US Federal Reserve Bank would cut interest rates. Nonetheless, the Dollar traded sideways for the next nine months, until the housing bubble burst and the ensuing credit crisis quickly metastasized to the rest of the economy.  The Fed responded by cutting interest rates by 50 basis points, and the Dollar began to unravel, losing 10% of its value in a matter of weeks.  After that point, the bad news began to pour in.

The oil-exporting countries delivered a one-two punch to the Dollar, first by announcing that the possibility of accepting payment for oil in other currencies, than hinting towards a collective dissolution of their respective Dollar pegs. The Canadian Dollar reached parity with its counterpart to the south shortly thereafter.  Countries in the developing world, including Brazil, Russia, and India, also witnessed surges in their respective currencies. The Chinese Yuan continued its slow climb, rising over 6% for the year, though this figure is probably closer to 2-3% in real terms. Even the Japanese Yen, previously held in place by the carry trade, notched an impressive performance as the credit crunch touched off a cascade of risk aversion.  Then, of course, there was the interest rate story: by the end of the year, US interest rates were only 25 basis points above EU rates, and Dollar bears were licking their lips.

The news was not all bad, however.  Foreign investors proved that they were willing to continue to finance the US twin deficits, though perhaps to a lesser extent than before.  There were even several high-profile investments in US financial institutions, led by Sovereign Investment Funds, which collectively claim hundreds of billions of dollars at their disposal.  In addition, the world’s Central Banks announced plans to pump over $500 Billion into global capital markets, which should especially benefit the Dollar since the US bore the brunt of the credit crunch.  Finally, economic data now indicate that US exports have been helped by the declining dollar. 

All things considered, it could have been worse.  Tune in later this week, as we unveil our forecast for 2008.

Original post by Jimmy Atkinson and software by Elliott Back

Last week, the Forex Blog recounted what happened across forex markets in 2007, in all of its drama. Now, we would like to offer a nice counterpoint, in the form of the major themes expected to dominate forex headlines in 2008, courtesy of Dow Jones. The list includes eight distinct themes, though there is some overlap.  Three of the themes pertain directly to the USD, which is the currency most worth watching in the upcoming year.  The fundamentals bode well for the Dollar; the economy has not suffered from the credit crunch nearly as much as economists feared; the cheaper currency has boosted exports; foreigners have proven surprisingly willing to finance the twin deficits.

Then, there is inflation, which has reared its ugly head in the US as well as abroad. Foreign Central Banks, especially in Asia, may have to tighten monetary policy in order to maintain price stability. Those countries with already-high interest rates, such as Australia and New Zealand, are expected to keep rates high.  The next theme, accordingly, is the carry trade, which should continue its run due to the aforementioned high interest rates.  Next is China, which will be watched on two fronts: its economy and its currency, both of which are expected to continue rising. 

The final two themes pertain especially to the Middle East: currency pegs and Sovereign Wealth Funds. As the Dollar declined in 2007, several nations in the Mid East mulled the possibility of de-linking their respective currencies from the Dollar, but thus far, the status quo has obtained.  Sovereign Wealth Funds also made a big splash in 2007 with several high-profile investments in the US, implicitly underscoring their their commitment to the Dollar.  They represent a growing force in global capital markets, and will be watched vigilantly in 2008.

View the Complete List Here

Original post by Jimmy Atkinson and software by Elliott Back

For at least the duration of the current administration, the official US stance towards its currency has been a "strong dollar" policy.  In hindsight, it appears that this policy was entirely baseless, since its was directly undermined by the simultaneous easy monetary policy, and thus it stands to reason that US policymakers did not actually believe that a strong Dollar policy was necessary to pursue.  In a recent op-ed piece published in the Wall Street Journal, one analyst outlines the case for a strong dollar, and by extension, why the depreciating Dollar is bad for the US economy. 

First, since oil contracts are settled in Dollars, a weak Dollar has directly contributed to high oil prices, which has several negative economic and geopolitical consequences. Second, a cheap Dollar is eroding the purchasing power of US consumers directly by making imports more expensive and indirectly through inflation. Third, the weak Dollar shifts the balance of economic power in favor of US competitors, which don’t need to grow as fast to keep pace with the US, in Dollar terms.  Finally, the recent weakness threatens the long term reserve status of the Dollar, which has important implications for economic growth and jobs creation.

On the other hand, argues the analyst, the conventional wisdom that a declining Dollar is necessary to correct the current account and trade deficit is bunk, since much of the trade deficit is accounted for by intra-company trade and since the current account deficit is generally overstated and not connected to currency valuations. In short, he argues, it is in the best interest of the US to align its rhetoric with its economic and monetary policies such that the long term luster of the Dollar is restored.

Read More: The Dollar and the Market Mess

Original post by Jimmy Atkinson and software by Elliott Back

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.

Original post by Jimmy Atkinson and software by Elliott Back

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. 

Original post by Jimmy Atkinson and software by Elliott Back

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.

Original post by Jimmy Atkinson and software by Elliott Back