My view on the dollar

• InEgoVeritas
• September 28th, 2009

The dollar seems to be the darling of the funding world. In the last months, it’s been used to fund what is called the carry trade as investors take advantage of its low borrowing cost to raise capital and invest into higher yielding assets abroad. The difference in yields is what is called the carry.

To Carry or not to carry?

Some pundits are quick to point out that the 3M USD LIBOR is the reason the dollar has overtaken the more traditional yen and franc in this role. Indeed the following graph shows that the speculative yen/franc-based carry positioning has been dead for quite some time.

The following table confirms that the 3M US LIBOR is the most competitive around. Is it sufficient in itself to justify an extended USD-based carry trade? I am of the opinion that it isn’t. If one looks at the other rates available, one sees that the yen and franc are better candidates in the long term. Their Central Banks, 1-2 year LIBORs and 10-year bonds have all much lower rates than the dollar.

What makes a currency interesting for the carry trade is the long-term prospect of low rates. A look at the core CPI y/y from Japan and the US signals that rates are most likely to remain lower in the former. Japan is headed back into deflation, the US is coming out of it.

So why is the dollar so attractive at the moment then? To get a fair answer, one must look at what is called the liquidity trap. The Fed has been injecting liquidity into the monetary system to stimulate lending. However, banks find it difficult to lend this money in the current environment. As @Bondscoop and @Fullcarry would tell us, banks have the options of putting this money at the Fed at 0.25% (on excess reserves at 0.15%) or invest it in assets providing better returns. This money finds its way to equities, corporate bonds, USTs and commodities. Some of that  money also gets invested in what I would call the excess-liquidity carry trade.

I am confident you now realise how precarious this excess-liquidity trade is. Suffice to say that at the first sign of the Fed pulling some of the stimulus away, rates will be driven higher and the whole thing will unwind. To make a long story short, the dollar is to remain the preferred funding currency until BB takes the punch bowl away… hiccup!

Why is the Yen so strong then?

This is another very good question. I suppose the fact that the USD is used as a funding currency shouldn’t really stop the yen from being used for the same purpose. I do believe that the yen will retake its place when the markets are less nervous. The proper carry trade requires a stable growing global economy, too much volatility/uncertainty kills it. When the fear of  a double-dip recession recedes, the traditional carry trades should start working again. In the meantime, not only do these funding currencies are stable but in fact they are strengthening.  A look at the following chart should shed some light as to why.

In the last few years, there’s been a high correlation between the 10-yr treasury and the $usdjpy. The further rates weaken in the US, the more $usdjpy gains. The Swiss and Nippon Central Banks have been quite clear (less so for the Japanese CB since the election but Hirohisa Fujii, the new finance minister has been more vocal as of late) that they aren’t pleased with their currency gaining too much strength as it increases the risk of further deflation. However, I think currency traders are a bit like teenagers in certain aspects. They like to push the limits with central bankers the way teens do with their parents. They want to know where the line will be drawn. Until there’s a clearer picture as to where the world economy is going, Forex traders have found nothing better to do. The yen has now reached the point that whenever it dips below 90, the Nikkei goes into a free fall. I believe this is the real line in the sand. Then again, I might be wrong. When Deutsche Bank, the largest Forex dealer out there, targets a $usdjpy at 80, one is allowed to wonder why the efficient market hypothesis has been around for so long.

What’s next for the dollar

I am not a dollar bull in the long run. I believe the narrow dollar index will stabilise around 76 for the remainder of the year. The reason is that I see both the yen and the franc soon starting to lose value.

The broad index should continue to slowly weaken as more money is likely to move from the developed world to the faster-growing emerging economies. This won’t be really visible in the narrow index as most of its components will also be under the same pressure.

For a significant change in the valuation of the dollar, one must keep an eye on the yuan peg. As the following charts show, there was a strong correlation between the value of the peg and the dollar from 2005 up until the start of the financial crisis.

Now that the peg has been fixed again, shorting the dollar is in fact shorting Chinamerica. Sellers beware: the Asian province of Chinamerica is growing at a furious rate.

Eventually, there will need to be a readjustment in favor of a stronger yuan if the current global imbalances are to be resolved. I suspect it might be the quid pro quo for the new IMF voting shares given to China. In the meantime, the yuan is well attached to the dollar, like a tail to a dog, though it isn’t clear which part is wagging the other.

IEV

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

blog comments powered by Disqus