U.S. Dollar and Euro - Review and Outlook
With so many global dynamics playing out, and the world's financial markets fixated on the political process (or lack thereof) in the Eurozone, driving market sentiment around the world, it may be a good time to take a deep breath, take a look back at where we've come from, and assess the likely implications going forward. Specifically, what are the implications for the U.S. dollar and currencies globally?
Firstly, let's look at what we've done this year. We made a number of macro investment decisions for our Merk Hard Currency Fund strategy, based on our assessment of how the global economy would play out. With deteriorating economic fundamentals in the U.S. and globally, we decided to reduce the strategy's exposure to the Canadian dollar, given the high levels of interdependencies between the Canadian and U.S. economies. Furthermore, we have been disappointed with the ongoing reticence displayed by the Bank of Canada to raise interest rates.
Weakening global fundamentals were largely driven by elevated concerns over the contagion effects of the periphery nation crisis in the Eurozone, and the apparent lack of a ready solution to satisfactorily tackle the issues. While we maintain a positive long-term outlook on the euro, we nonetheless decided to reduce the currency's allocation during the year, largely driven by our assessment that there was an increased likelihood of the European Central Bank (ECB) pursuing more expansionary monetary policies. (We have subsequently become much more optimistic on the outlook for the euro - discussed below.) We also decided to reduce the allocation to the Swiss franc this year, based on valuation fundamentals and increased intervention risks. In our assessment, substantial amounts of speculative money had rushed into the currency, resulting in an overvalued franc. At the same time, the Swiss National Bank (SNB) became evermore vocal, threatening currency intervention, which ultimately culminated in the SNB intervening to peg the franc to the euro in September. We also took the opportunity to take profits in our gold holdings, given it had experienced considerable price appreciation through the first half of 2011.
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We decided to redeploy much of the currency exposure into the Japanese yen, given the backdrop of deteriorating global economic fundamentals and the fact that the Japanese banking system appeared to provide relative safety (which in itself is a sad commentary on the state of the global finance industry). The SNB's intervention to peg the Swiss franc to the euro effectively constrained the supply of "safe haven" currencies, and on net, we believed this would benefit the yen, given its traditional "safe haven" status, particularly with a backdrop of ongoing heightened market volatility. Japan's leadership structure also remains weak, and we therefore considered the Bank of Japan was unlikely, in the near term, to embark on any substantial expansionary measures that could undermine the strength of the currency. We also increased the New Zealand dollar and Norwegian krone exposures, on our assessment that the U.S. Federal Reserve (Fed) may be forced into more expansionary monetary policies, which in turn may be positive for those currencies highly correlated to commodity prices and expectations for global growth. Notably, the outlook for interest rate increases in New Zealand remained positive while expectations for many other currencies declined substantially throughout the year.
The market's focus, for the majority of the year, was Europe. Specifically, the periphery nation sovereign debt crisis and concerns surrounding global contagion. As a result, we witnessed heightened levels of market volatility and general selling of perceived risky assets, as evidenced by the decline in the S&P 500 Index (-8.7% YTD through Sep 30th, 2011). Policy makers in Washington didn't help appease market concerns: leaving the decision to raise the Government's debt ceiling to the last minute only exacerbated market fears of a U.S. default and further degraded investor's view of policy makers; the whole situation could best be described as a debacle. Indeed, Standard & Poors subsequently downgraded the credit rating of the U.S. government, citing the inability of the political leadership to come together and agree on a plan to sustainably rein in the deficit over the long term as a key reason for downgrade. We consider these developments have further eroded the safe haven and reserve currency status the U.S. dollar has held for so long, and continue to view the outlook for the U.S. dollar negatively over the medium to long term.
Despite the downgrade, U.S. Treasuries have strengthened recently, largely driven by the risk aversion exhibited in the market, and further compounded by the U.S. Federal Reserve's (Fed) decision to instigate "Operation Twist" - selling Treasuries at the short end of the yield curve and reinvesting the proceeds in longer dated Treasuries. Thus, flattening the yield curve by artificially depressing yields at the long end. It appears there was a great deal of debate surrounding this decision - indeed, three voting members of the Federal Open Market Committee (FOMC) dissented to the decision (Fisher, Kocherlakota, and Plosser). On the other hand, minutes from the meeting show there was support for further expansionary monetary policy, or quantitative easing, which would constitute "QE3". It is our assessment that the likelihood of the Fed instigating QE3 has risen significantly, in part due to the weakening economic outlook, but also because of the composition of voting members next year. All three dissenting voices will be replaced in 2012 and the average monetary policy stance of voting members will become much more dovish (only one voting member is considered a hawk - Jeffrey Lacker, the Richmond President)¹. With inflation expectations declining, we consider Fed Chairman Bernanke may again present the need for further easing, arguing deflationary risks have become elevated, or at the very least, that further easing will not generate significant inflationary pressures. We believe the impending FOMC composition may consider this argument compelling, and is likely to err on the side of overstimulation.
All of which leads us to believe that the outlook for the U.S. dollar remains to the downside. With continued expansionary monetary policy likely here in the States, and an apparent lack of such policies elsewhere, we believe the divergence in monetary policy is set to resume and likely conspire to further erode the value of the U.S. dollar. When a central bank prints money to finance its quantitative easing purchases, whether that is Treasuries or any other asset, that central bank increases its balance sheet and in so doing, increases the supply of the currency. Without an offsetting increase in demand, increases in the supply of any asset naturally puts downward pressure on the price of that asset - these dynamics are thus likely to put downward pressure on the U.S. dollar. However, there's an opposite side to this trade: because currencies always trade in pairs, currencies of countries not following such expansionary policies are likely to appreciate relative to the U.S. dollar. It is within this context that we believe the euro, amongst other currencies, may offer strategic value.
With all the market concerns surrounding Europe, we would be remiss not to mention why we hold a contrarian, optimistic view on the currency over the medium and long term, relative to the U.S. dollar. Europe certainly has problems, but in an odd way, it is the inflexibility of its political make-up that may lead to a stronger euro over the foreseeable future. With no central Treasury to decide on fiscal policy for the Eurozone as a whole, the political process to agree upon almost anything is convoluted and time consuming. We have seen it time and again, and it has caused no end of consternation regarding sovereign bailouts and the European Financial Stability Facility (EFSF) in particular. Many individual countries find themselves with very weak political leadership, but interestingly, have instigated, in many cases, very strict austerity measures with opposition support. The issues facing the Eurozone are significant, and there is no simple, easy solution; it's likely to be a drawn out process rectifying years of malinvestment brought about by unconscionably low funding rates for periphery nations (Greece could borrow at rates similar to Germany for years leading up to the crisis). In turn, economic growth may be restrained over the foreseeable future. Note, however, that economic growth is not necessarily a precondition for a strong currency; it is not incompatible to have poor economic growth on the back of a strong currency - just look at Japan.
We believe two key reasons have contributed to Japanese yen strength - weak leadership and a current account surplus. Weak leadership meant that Japanese politicians had little influence on the Bank of Japan, thus monetary expansion was constrained and the supply of Japanese yen remained relatively stable. In fact, the Japanese were one of the only central banks not to drastically increase the size or composition of its balance sheet in reaction to the financial crisis in 2008. On the other hand, a country with a current account surplus does not require investment from abroad to underpin strength in its currency; it essentially needs investors to sell its currency to stop it from appreciating. The opposite is true for the U.S. - the present current account deficit requires purchases in U.S. dollar denominated assets every single business day just to keep the dollar from declining.
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On the above two factors, the Eurozone is not so dissimilar to Japan: the Eurozone has a broadly balanced current account, fiscal union is disjointed at best, and many individual nations have very weak political leadership. Furthermore, the ECB has a sole mandate of price stability, and is reticent to provide any direct bailout funding or directed asset purchases to the financial industry, or specific sovereigns, for fear of overstepping its bounds (or being taken to court by the Germans). The ECB is also fiercely independent. As such, there is little political influence to follow expansionary monetary policies. If anything, the opposite is true, given the criticism leveled at the ECB from Germany. Contrast this with the Fed, which has a dual mandate to foster maximum employment and price stability, which inherently creates conflicts between its two objectives, and arguably lends itself to more expansionary policies. To this point, whereas the Fed considers inflationary pressures to be transitory, the ECB is taking inflation very seriously, and likely a key reason why it did not cut interest rates at its most recent meeting in early October. Indeed, with inflation running around 3% in the Eurozone, combined with the ECB's sole inflation mandate, there appears to be strong fortitude to maintain interest rates at present levels. As a result, we consider the euro can appreciate on the backdrop of weaker economic growth and continued divergence in monetary policies.
Turning to Asia, we continue to see upside potential in the Chinese renminbi and believe policy makers will continue to be incentivized to allow the currency to appreciate to tackle domestic inflationary pressures. We do not think China will allow its currency to appreciate because the U.S. Senate passes a bill aimed at pressuring the Chinese. If anything, this act simply creates greater political risk and protectionist pressures, ultimately leading to lower levels of global investment and efficiency. (Incidentally, YTD through Sep 30th, 2011, the Chinese renminbi was one of the only Asian currencies to appreciate, returning over 3.5% during this time frame). Inflation is running above 6% in China, with food and labor cost inflation running substantially higher than that. Moreover, actual inflation is likely to be somewhat higher than the reported figures. In our opinion, the prime motivation for the ruling Communist Party to stay in power is to foster social stability; inflation causes a destabilizing effect on social stability - it should come as no surprise that the Chinese attempted to contain news coverage from the "Arab Spring", which was, in large part, caused by rising levels of inflation and lower standards of living. Interestingly, these inflationary pressures in Asia are having an effect in the U.S. through imported inflation. Recent import price inflation has been running well over 10%; the last time we saw these levels was in the spring of 2008 when oil was approaching all time highs.
Elsewhere in Asia we favor Asian countries that produce goods and services at the mid to high end of the value chain: higher end producers have greater pricing power, whereas low-end producers compete predominantly on price. It is for this very reason that we see the stronger Asian countries, like China, having the ability to pass on increased costs through exported inflation, or U.S. import price rises, described above.
With so many global dynamics to play out, we believe numerous opportunities are evident within the currency asset class, and continue to believe that currencies may provide valuable portfolio diversification benefits and upside potential.
¹Generally speaking, a central banker may be considered a hawk if his or her monetary policy stance is perceived to focus more on inflation and less on expansionary policies; generally speaking, a central banker may be considered a dove if his or her monetary policy stance is perceived to focus more on stimulating employment and economic growth and less on inflation.
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