Summer Doldrums Already?

When you come to a fork in the road, take it.

-Yogi Berra

Until Monday's rally, the dollar was range-bound versus the EUR and JPY in a fairly narrow band. Even after yesterday's move, the near-term ranges remain relatively narrow - 1.35 to 1.4350 for the EUR and 94 to 100 for the JPY. While these ranges will not hold forever, there are no compelling reasons for them to break in the near term, nor a clear sense of which direction the break will occur. As a result, currency volatility has fallen slightly. Historically, lower currency volatility and increased risk appetite have resulted in a pick up in carry trades. That is not as likely in today's environment because even though volatility has fallen, it is still relatively high compared to recent years. More importantly, risk appetite is down significantly from what it was before the housing and financial crises hit us - capital preservation still gets the nod over speculation.

When and if carry trades make a comeback, there is a third currency to add to the list of "funding" currencies in addition to the JPY and CHF: the dollar. Like the JPY and CHF, rates are low and are unlikely to rise rapidly, despite falling bond prices and rising long-term yields. That is a potential drag on the dollar down the road. I do not believe the Federal Reserve is done with quantitative easing. Despite all the recent optimism about a recovery, I think it will take several quarters to unfold and will be tepid at best. I believe as long as inflation remains nonexistent (it will, for several quarters) and as long unemployment keeps rising and demand remains weak (at least until the middle of next year), the Fed will keep Fed funds on hold and keep a lid on market yields through bond purchases in the market. Low short-term rates, a weak economic recovery, capital flows turning increasingly dollar-negative and longer-term inflation concerns are a good breeding ground for short dollar/long other currency carry trades for the next year or more. The trick is to identify the currencies that will outperform.

I believe we are at the beginning of a trend that will see a significant, long-term outperformance of undervalued, higher growth emerging market currencies at the expense of some of the major currencies. The dollar will lag and probably the EUR and JPY as well on concerns about a weak recovery and low rates. The EUR is somewhat overvalued as well, while the Japanese economy continues to languish and flows are still not supportive. The GBP has done well of late, as it was oversold and an economic recovery seems closer at hand, but concerns about mounting deficits and a sovereign downgrade will limit further gains. Finally, the Canadian and Australian economies appear stronger and have better prospects, but both currencies have anticipated that and offer limited value from current levels.

Getting back to my initial thought, I believe most major currencies will trade in narrow ranges for the next few months in the absence of significant new information. As long as we face the prospect of a slow, painful global recovery with the U.S. and Europe lagging, emerging market currencies such as the CNY, INR, BRL and others will grind their way higher at the expense of the majors.

In my opinion, the dollar can only rally meaningfully if one of two things occurs: another significant meltdown - which results in a panic-induced flow back into treasuries and the dollar - or a dramatic upturn in our economic fortunes. Anything in between should result in further erosion of our currency. The reasons given will include carry trades, concerns about our deficits, concerns about future inflation, concerns about the dollar's reserve status and concerns about capital outflows. The truth is the dollar will probably fall because there are more attractive investment alternatives elsewhere for the reasons above and more.

For now, major currencies are relatively stable because flows are balanced and the market is somewhat confused about how the global recovery will play out. As we approach the fourth quarter, I believe optimism about a strong, quick recovery will fade and that is when we will see the bulk of the dollar's decline versus the emerging market world. Predicting what happens among the major currencies is more difficult; it depends on where they are at the time, what has been priced in and how the flows play out.

The behavior of equity markets will play in a role in this process. Currently, equities are struggling to advance further in most regions except Asia, weighed down by surging commodity prices, soaring bond yields and a perception they have gone up too far and too quickly. If I am right and growth and inflation expectations are ratcheted down in Q4, this will provide a more favorable backdrop for equities, but only in those markets where growth expectations remains alive and well. I believe that is when we will see another wave of outflows from developed markets into the better performing emerging markets, and it is this capital movement that will be the catalyst for further emerging currency gains.

There could be an opportunity here. Volatility (and therefore the prices of options) is high for most major currency pairs, but I expect the currencies themselves to remain relatively stable. Volatility remains cheap for most of the larger emerging market currencies, however. Companies that need to hedge major currency exposures can use this period of relative stability to lock in hedges through the forward markets. Both forward and option hedges look attractive for hedging emerging market payables given relatively "cheap" pricing, especially if events unfold the way I believe they will. Summers are all too short and forks in the road fly by. Not all forks in the road are worth taking - perhaps just those that protect emerging market payables...