Time to Pay the Piper?

In a world of imploding equity valuations and panic-stricken debt markets, currencies have been relatively stable. Stability does not always mean properly valued; in my opinion, the dollar is far from properly priced.

Not long ago, "fundamental" data moved currency markets; trade surpluses and deficits, employment, inflation and GDP growth were what mattered. Over time, as hedge funds grew more dominant and capital more mobile, it was short-term capital movements that by and large dictated what happened in currency markets. Capital moved for high real rates of return (the carry trade being an example) and the prospect of short-term speculative gain (from currencies themselves or from a currency's equity and debt markets). As the financial Armageddon unfolded, it has all been about capital preservation, and the dollar has benefited greatly.

Money has flowed out of various "riskier" asset classes (emerging markets, equities, high-yielding currencies) into the U.S. Treasury market. Yield clearly has nothing to do with it. Bonds with double-digit yields have been sold in favor of short-term paper yielding a handful of basis points.

So far, many of these trading strategies have paid handsome dividends. Capital has been preserved and many of the assets sold have continued to plummet. However, investing at 0.10 percent is not a viable long-term strategy unless we have global deflation and plummeting asset values for some time to come. The strategy also treats all currencies other than the dollar and yen as relatively toxic. Once again, it may have worked short-term, but is unlikely to in the long-term.

The dollar has had some positives working in its favor: a proactive Fed; a large dose of fiscal stimulus in the works with more to come; a Treasury market that is considered a safe haven by most investors; and relatively attractive currency valuation vs. some of the developed economy currencies which have similar problems (slow to negative growth, a financial industry in turmoil, etc.) but higher cost structures and more restrictive labor laws that make them uncompetitive. In a general sense, Europe and Britain fall into that category.

However, there are many more currencies representing faster growing economies which are relatively unscathed from the financial meltdown. Their sins have been an over-reliance on exports (as opposed to domestic consumption) and falling prey to short-term capital movements out of their markets.

At some point, focus will return to what should really matter in the medium- to long-term: sustainable growth rates, low unemployment, fiscal and budget surpluses and low inflation. When that does happen, how will it impact the currency of the largest debtor nation in the world, saddled with huge structural budget and trade deficits and an over-leveraged, tapped out consumer?

The Road Ahead

The dollar appears to have lost upward momentum and I believe we may see further weakness in December. Decembers tend to be dollar-negative in general and even though the dollar may get a slight bounce from year-end position-squaring, I believe we will end the month with a somewhat weaker currency. Data will almost certainly continue to paint a negative picture, especially the employment number on Friday. In addition, capital flows should be increasingly less USD supportive, as much of the repatriation trade presumably occurred in October and November. Finally, calmer equity and bond markets may signal a reduction in risk aversion, and that should undermine dollar strength as less capital is likely to find it way into the U.S. Treasury market.

While I expect the EUR to lag other currencies in strengthening vs. the USD, a break above the 1.30 to 1.31 area could result in 1.38 to 1.40 later this month, but only if support in the 1.23 to 1.25 area holds. If that support level fails, the EUR could test the 1.15 to 1.20 area. The GBP has performed better recently, but gains above 1.60 may be hard to achieve and a break of 1.40 would shift momentum to the downside. With Japan's economic picture worsening and risk aversion lessening, the JPY should under-perform over time; for now, it should remain in a 91-98 range.

The AUD has stabilized and with data relatively upbeat, forecasts of future rate cuts possibly overdone and commodity prices appearing to form a base, there is scope for more appreciation. This might be the case for other commodity currencies such as the NZD, CAD and possibly the BRL as well. Eastern Europe (Russia included) continues to struggle and I see no immediate respite, as soaring deficits, slowing economies and increased capital outflows make for an unhappy combination. I am positive on most Asian currencies towards the middle of 2009, but in the near-term more currency volatility and weakness are possible, as currencies continue to struggle under the weight of lowered growth forecasts and capital outflows.