Economics is extremely useful as a form of employment for
economists.
- John Kenneth Galbraith
All economists and currency strategists have a view on the
dollar and its future direction. They fall into two distinct camps
for the most part; one expects a continuous rally in risk assets
and a fall in the dollar, while the other predicts another strong
downtrend for equities and other risk assets and a strong rally in
the dollar. Both arguments appear logical at first glance, but
obviously they are only as good as their base assumptions and
projections about future events. However, very few forecasters
predicted trendless range trading and, despite some dollar weakness
at the end of last week when this article was written, that is what
we have seen for the last couple of months.
Between June 1 and July 31, as the
attached chart shows, the dollar has lost
ground to all G10 currencies, but not by a particularly meaningful
amount, even though losses have accelerated this week as equities
rallied. Emerging market
currency performance has varied, with Eastern
European currencies playing catch up and Asian currencies pulling
back from earlier gains.
In my opinion, the main reason for the general lack of direction to
this point is the market's focus on the global recovery. Everyone
wants to see how it will unfold, what countries or regions will
lead the way and what sort of growth we will see. For now, we
appear to be seeing the beginning of a recovery (we will only know
for sure with the benefit of hindsight in a few months), but
signals are still somewhat mixed and the durability of the recovery
is very much an open question.
While this uncertainty persists, currencies have and will continue
to trade in groups, with very little movement within the groups.
The low interest rate currencies, or the "funding" currencies in
carry trades, move inversely with the equity markets - they rise
when equities falter, but lose value when equities and risk
appetite bounce. They used to be principally the JPY and CHF, but
that list has grown to include the USD and more recently, perhaps
the EUR as well. The high yielding currencies obviously work in the
opposite direction. There aren't many true high yielders in the
world today, but relatively speaking, the AUD, NZD and many
emerging market currencies would be in that group. There are also
the commodity currencies (the RUB, BRL, CAD, plus the AUD and NZD
as well) that tend to move in the same direction as the high
yielders for the most part, but have underperformed of late as most
commodities have languished despite the pickup in risk appetite.
If, in fact, investors are marking time before making bets on
currency movements, how is it likely to play out? If we see a
robust recovery in the U.S. and elsewhere, will the dollar decline
sharply? If the recovery is anemic or even non-existent, will the
dollar soar? I don't think either scenario can be taken for
granted.
My basic premise is that the dollar and U.S. Treasuries are
temporary safe havens at a time of uncertainty. Once the
uncertainty is resolved, I believe flows will normalize. In other
words, currency valuation (using various metrics), investment flows
and speculative flows (looking for higher yields and better
performing asset markets) will come back to the forefront. I have
been bearish on the dollar in general, but believe that when we do
begin to see trends emerging, not all currencies will move in the
same direction or by the same magnitude versus the dollar.
Currency valuation combines many elements, including domestic
economic growth, trade and current account surpluses or deficits,
purchasing power parity (the "Big Mac Index" being a proxy for
that), changes in productivity, etc. Without getting overly
granular, the euro is by most metrics currently overvalued, the AUD
is approaching overvaluation, the JPY is neutral and the GBP and
CAD slightly undervalued. The CNY is probably the most undervalued
of any major currency and most Asian currencies are somewhat
undervalued as well. As a general comment, emerging market
currencies are and have been underpriced of late as a result of the
perceived risk of owning them in times of economic stress.
Investment and speculative flows dominated currency markets for
several years, dwarfing the impact of currency valuation. I believe
capital markets and market participants will emerge from this
recession more cautious, with less leverage available and more
attuned to longer-term valuation. As a result, the impact of hot
money will diminish and that will reduce the disadvantage faced by
"funding" currencies relative to high yielding currencies. As a
result, I would be cautious about placing long AUD and NZD
positions versus the JPY at this stage to chase the current risk
rally, for example, which has been a fairly common carry trade. I
would be far more comfortable being long the CNY versus a basket of
currencies, including the USD and EUR. In other words, I believe
the pendulum will swing towards valuation and away from
speculation, at least for a couple of years.
Where does this leave the dollar? Somewhere in the middle of the
pack. It is fairly to somewhat undervalued versus the G10
currencies, perhaps somewhat overvalued versus a handful of
emerging market currencies. The relative pace and strength of our
recovery will have an impact and there is a chance that the first
few months of a broad recovery will see dollar weakness as money
flows out of Treasuries. After that, I believe we need to pay
attention to specific currency pairs, not merely assume they will
keep trading in blocs like is currently the case.
A final thought; at the time I wrote this, the dollar was flirting
with an important support level for the Dollar Index (DXY) at
78.30. A close below that could open up a move towards 76, or a
further drop of 3 percent for the dollar. In my opinion, that does
not materially change the way I would approach the dollar six to 12
months out when the global recovery should be gaining momentum.