The holiday had brought tidings of comfort and joy for the USD and the U.S. market. Apart from the Asian economic recovery, recent U.S. employment data has lead to optimism that 2010 will bring further sustained economic improvement in the U.S. U.S. stocks marked recovery-trend highs, long yields ascending to four-month highs and the USD index rebounded to three-month highs.
Speculators finally abandoned their bet against the USD and were net long of the USD during the last two weeks of December, the first time since May according to Commodity Futures Trading Commission data. However, many investors and analysts warned against reading too much into this year-end rally because gains made during the thin holiday sessions could easily reverse when the market returns to normal liquidity after the holidays.
The USD is Not Doomed Yet
The big question is whether the medium-term outlook has changed in a way that warrants sustainable USD strength. My inclination is that the USD might be able to hold on to its recent gains during the first half of 2010 for several reasons.
First, in terms of relative growth, the demise of the USD as a result of the weak U.S. economy has been greatly exaggerated. Certainly, the credit crisis had its origin in the U.S., but it developed into a global phenomenon. Despite the disappointing growth and employment outlook in the U.S., the euro zone is equally one of the slower growing regions of the world. The consensus is that the region will grow by only 1.3 percent. The problem is that growth will vary greatly from country to country, thus complicating the recovery. Before the crisis, the euro zone was running a budget deficit of only 0.6 percent of GDP. Today the shortfall is 6.0 percent. This might not seem high, but some European countries have far higher deficits.
The euro outlook is further complicated by the recent near-default situation in Greece and pending sovereign problem in other euro zone countries such as Spain. The downgrade in Greece will continue to trouble the euro as it raises the possibility that more downgrades of euro zone sovereign debt are to follow, which could trigger serious banking problems and curtail the current economic recovery. Until the sovereign debt situation has improved, sentiment will remain fragile in the euro zone. Investor fear will be sufficient to weigh on the EUR at least for H1 2010. In the face of low output and declining sovereign credit rating, it will be difficult to foresee further ECB tightening next year.
Second, the downside risks to global economic growth will continue into 2010 and negatively impact risky assets. Recent rises in global assets have been artificially propelled by excess global liquidity post-Lehman crisis, leading to mispricing of fundamentals. Risk appetite will shrink tremendously sometime in 2010 when the excess liquidity gradually plows back to the real sectors of economies and governments gradually remove liquidity from the system. As a result, USD will rally. USD will benefit from position liquidation, deleveraging and safe-haven demand for the U.S. Treasuries. USD will shine again as the prime reserve currency in the world. Despite talks of sovereign diversification and alternate reserve currencies, the U.S. is still the only country that has the economic strength, political freedom and market depth as a reserve currency.
In addition, the USD's year-end rally is more than simply a result of squaring of year-end positions. The current USD level signifies a fundamental shift in the direction of the USD technically, rather than a brief correction and it should continue to appreciate against the major currencies, at least for the first half of 2010.
Even JPY Moved Against the USD
Defying any fundamentals, JPY has appreciated consistently against the USD as it is being widely used by investors as a "carry" currency to fund other risky plays. This time, USD gained even against the JPY as investors succumbed to the prospect that the Fed will seek to exit from its quantitative easing sooner than the Bank of Japan. Deflation woes in Japan, a disappointing new government and the stark reminder that the Nikkei is off over 70 percent in nominal terms over the last 20 years is weighing on the JPY. The USD will rally against JPY to catch up with the broad USD strength, but it will be a slow creep forward, rather than a significant jump to close the gap. At current low USD levels, the threat of intervention, accompanied by rhetoric from the Bank of Japan, will be more credible.
Risks to the USD
Despite the above USD supportive factors, there are still potential factors that will drag the USD back on a down trend.
First, global economic recovery might gain traction to the extent that investors become more confident in favorable global economic performances and unworried by the prospect of monetary tightening. In such a scenario, risky assets and high-yielding currencies will be in demand, but USD and other low-yielding funding currencies will be sold.
Second, the extraordinary budget deficit of the U.S., currently at close to 12 percent of GDP, will have negative consequences. If the economy dips back in Q1/Q2 next year, U.S. policy makers will surely be providing more stimulus, especially ahead of the November midterm elections, further aggravating the budget shortfall. It will be questionable whether the U.S. can maintain its AAA status by then. Selling of the USD will resume in that case.
However, if any of the above events occur, it will likely be during second half of 2010. In the meantime, USD deserves some breathing room.
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