The Long and Short of It

"That's the secret to life... replace one worry with another..."
-Charles M. Schulz, Charlie Brown

Risky markets are notoriously shortsighted and the foreign exchange market is no exception. However, much of the short-term movement in currency markets was caused by speculators and their ranks have thinned significantly over the past year. Many hedge funds have closed their doors, as have the proprietary desks of most large financial institutions. With the absence of many of those large players, surely markets should be swayed more by "real money" investors with a longer-term perspective? Not if you go by the evidence.

In my opinion, current dollar strength is a testament to short-term thinking. It has gained more in percentage terms versus the JPY in February than in any month in about 12 years. The Indian rupee is at record lows, the Korean won is at 11-year lows, the euro, the British pound and the Canadian dollar are sagging. Why this surge at a time our economy is going through the worst economic crisis since the 1930s with no end in sight?

There are several reasons, most of them short-term. Risk aversion has boosted the greenback's fortunes, as money flows into U.S. Treasuries. The JPY has begun to weaken as well, as the carry trade impact has run its course and it is apparent just how poorly the Japanese economy is doing. Eastern and Central Europe are imploding and this has pressured the euro, as European banks are heavily exposed and widespread failures could result. Asian currencies are getting hurt by capital outflows and a downward adjustment of GDP growth estimates, especially for the more export dependent economies such as Korea, Taiwan and Singapore, which have been especially hard hit as U.S. consumer spending slows. Weak commodity prices have hurt currencies like the AUD, NZD, CAD and BRL. The UK economy and financial sector have suffered and as their rates gravitate towards zero, the pound continues its slide. With our rates essentially at zero, rate cuts elsewhere reduce the dollar's relative yield disadvantage.

In other words, just about every significant currency is the world has fallen against the greenback recently. Are we really this bastion of strength and safety? Going back to my initial comments, yes we are in the near term � there is a virtual perfect storm favoring the dollar. Longer term (2010 and beyond) there is the very real possibility that the dollar will hold its own against some currencies, possibly including the euro, as Europe struggles with restoring economic growth, keeping the European Union from falling apart, rebuilding its financial sector and bailing out much of Eastern and Central Europe, all the while coping with mounting budget deficits and rising borrowing costs.

However, if we look to the longer term and compare ourselves to most countries in Asia and Latin America, and even throw in Canada, Australia and New Zealand for good measure, the picture changes. Compared to most of those countries, our financial system in is disarray. Employment and housing will remain a drag on our economy for quite a while longer and we will have mounting budget deficits and stubbornly high trade deficits for many years to come. As a result, capital flows will likely turn far less dollar-supportive. Add to that the possibility of quantitative easing by the Fed later this year and protectionist sentiment building in Congress and you have the possibility of a significant decline in the dollar. That decline, if it occurs, will be received favorably by an administration and a Fed that would welcome the export boost and anti-deflationary impact of a weaker currency. Once again, European currencies in general might continue to remain weak, but I think they will be the exception, not the rule.

Those who have reaped gains from the dollar's ascent would do well to protect their profits and their investments. When the dollar turns south, as I believe it will, it will possibly surprise many with the speed and magnitude of its decline. The long term may not be quite so far away.