Currency Musings

"If you don't know where you are going, any road will get you there."

- Lewis Carroll

It has been a few weeks since I last wrote this column. There is clearly more optimism about the prospects for a global recovery than there was a couple of months ago and equity markets have rallied as a result. There had been some slightly more constructive data here in the U.S. as well, but some of those indicators have since stalled. The global optimism can partly be explained by the significant easing of financial conditions here and around the world and increasing optimism in Asia based on a belief China has turned the corner. On the other hand, rising unemployment and weak consumption remain severe drags on our economy.

As I had predicted, the dollar has slipped. The dollar index fell to new lows for 2009 on Friday, while the euro came closely to matching its early January highs. The weakness has been broad-based; even the JPY has participated, which negates the argument that the dollar's weakness is purely a function of rising risk appetite. Had that been true, the JPY and CHF should have been weaker vs. the dollar and substantially weaker on the crosses, which is not the case.

I believe this dollar sell-off is largely a reflection of where markets perceive the U.S. is in its economic cycle compared to the rest of the world and the relative prospects for a bounce. Quantitative easing (QE) is predictably beginning to hurt the dollar, and given the likelihood of a long period of lackluster demand and consequently no inflation concerns, it is likely the Fed will stay on hold for a long time - at least until the middle of next year, possibly into 2011 in my opinion. As of now, it appears other G10 central banks, including the BOE, ECB and RBA, will begin to raise rates somewhat earlier. It is increasingly likely that some of the money currently invested in U.S. assets by the Chinese and other foreign investors will look for new homes outside the U.S. As a result, we might be approaching a perfect storm - low short-term rates, a nervous bond market on concerns about rising fiscal deficits, waning investor interest, and finally, decreasing risk aversion, which had served as a prop for the dollar until early March.

That does not mean the dollar's downtrend is a one way bet forever. Markets tend to be volatile when they are turning, and uncertainty about the timing and pace of the global recovery should increase volatility and make longer-term trends less predictable. The dollar's challenges listed above are relatively mild when compared to the GBP, for example. Britain is more likely to suffer a ratings downgrade than we are over the next year, as public debt in the UK is likely to approach 100 percent of GDP. That will force austerity measures in the current and future budgets and scare bond investors, probably leading to medium-term currency underperformance and higher long-term rates.

Finally, let's bear in mind that in this global era of weak economic performance, declining exports and non-existent inflation, most governments favor, even actively seek, weaker currencies. Expect howls of protest from Europe, Japan, Australia and others if the dollar continues to fall and their currencies rise, which would tax their domestic economies and tighten monetary policy.

India got some good news last week and the Indian rupee (INR) has surged. The elections gave a broader mandate to the ruling Congress Party, enabling them to form a government without relying on help from the communists as they have for the past five years The result is optimism about future economic reforms, notably on removing more barriers to foreign direct investment in India and ownership of Indian companies, and also reform in areas such as labor law. Historically, reforms have tended to move at a slower pace than anticipated and this time may prove similar, despite hopes to the contrary. India was on a verge of a sovereign downgrade on concerns about rising fiscal and external deficits. The elections should result in a surge in offshore investments, which could swing the balance of payments back to a surplus despite a lingering current account deficit. Even with a substantial domestic economy, India needs a global rebound to rejuvenate its export sector and provide a boost to GDP. On the other hand, it is an importer of oil and other commodities, making it susceptible to rising commodity prices. Despite these challenges, growth is projected to rise to over 6 percent in this fiscal year. Post-election optimism has caused the Indian stock market to rally by 14 percent last week, and the INR by almost 5 percent. While further gains might be harder to come by in the near term, the elections have reduced downside threats to the economy and currency and I believe the INR will be at 46 or stronger by the end of 2009.

Though much has changed in the past few weeks, there are still some enduring themes, the main one being continued weakness for the dollar until positioning, valuation and an uptick in the economy result in a rally. I don't see that happening to a meaningful extent until 2010. I expect the GBP to underperform most major currencies for several months. Europe and Japan have their own challenges, but both the EUR and JPY can rally further vs. the dollar. Despite the recent rally, the CAD, AUD and other commodity currencies still have some upside - as do some emerging market currencies - as long as equity markets remain strong to stable and risk appetite remains intact. Betting on stable equities and continued risk appetite is never safe, but it does appear as if cyclical factors favor those trends globally, perhaps less so here at home. Asia remains the part of the world best positioned to rebound, especially if they can wean themselves off their reliance on exports by boosting domestic demand.