Hard and Asian Currencies in 2008: U.S. dollar bounce may be elusive
As pundits on Wall Street want to hop on the next trade, they pronounce the U.S. dollar is due for a bounce. In favor of a bounce speaks that popular media cover the dollar's demise; and the Economist shows a burning dollar bill on its cover page while discussing the "panic" out of the dollar. While short-term currency moves are notoriously difficult to predict, it is rather worrisome that contrarian indicators pose the best arguments for better fortunes for the greenback. We also beg to differ with the Economist: there is no panic out of the dollar, at least not yet.
Traders eager to jump on the "next" trade may be in for a disappointment. It is the same disappointment the Federal Reserve ("Fed") has to deal with: the issues weighing on the U.S. dollar and the U.S. economy don't seem to want to go away. The markets tend to "look ahead" - but rather than facing a recovery, the U.S. economy may be sliding further into recession.
The forces for further credit contraction, and with it a slowdown in economic activity, are firmly in place; and there may be little the Fed can do about it. Over a decade ago, former Fed Chairman Greenspan gave his infamous warning on 'irrational exuberance'; his market impact was rather short-lived and the tech boom continued for years before the bubble burst. Ever since then, Greenspan has said that the Fed should not try to prevent bubbles from occurring. Alas, when homeowners created money by using their homes as ATMs, when hedge funds, private equity firms and banks increased money supply by gearing themselves up to make more leveraged bets, the Fed's rate hikes were rather timid.
This summer, when all those risk takers realized that world is not risk-free, they pared down their leverage. Those who could not, e.g. those who had used mortgage-backed securities as collateral, faced serious liquidity problems. As leverage is pared down and more assets are sold than bought, prices adjust downward. But because such downward price adjustments trigger further margin calls (calls by lenders to provide more collateral for leveraged bets), the most leveraged players have a vested interest in preventing price discovery from occurring.
The Fed is trying to solve the current crisis with a textbook formula; trouble is, the textbook was written by former Chairman Greenspan. The idea is that the current crisis is just like the Savings & Loan crisis of the 1980s. Let the Fed provide enough liquidity, and it will allow the troubled players to move the trouble to special entities. While the problems may take a while to work out, the financial system as a whole can move on once the special entities have absorbed the bad loans. Except that the market doesn't play by the Fed's rules: those in trouble are not taking advantage of the easy money from the Fed to clean up their books. Sub-prime borrowers and holders of asset mortgage securities continue to be shut out of the credit markets; the lowering of the Fed Funds rate does not help those who would need access to credit the most.
It's the market that has decided to reign in available credit. This tightening by now extends far beyond the mortgage market, but has spread to all sectors of the economy. Rumors make the rounds that stretched banks are asking their customers not to draw on their lines of credit. Global credit markets have seized, increasing the cost of borrowing to just about everyone. The Fed's response is to simply make money even more easily available, so that increased risk premiums still result in attractive effective interest rates.
To make matters worse, the sub-prime "bailout" promoted by Treasury Secretary Paulson is likely to tighten credit further. This bailout, in our assessment, will not reverse the trend in the mortgage sector; the negative headlines will persist. More importantly, though, the government has made it clear that it is willing to modify mortgage terms to alleviate the hardship on consumers. Paulson's claim that the bailout is a voluntary one is little relief here, as Congress had made it clear that it is ready legislate a solution should it be necessary. As a result, lenders will have to price in the risk of government intervention on future loans. This has implications far beyond the mortgage industry: foreign lenders may demand higher yields when financing U.S. deficits. Given the choice of serving the elderly or paying foreigners holding U.S. bonds, the U.S. government has made it clear where its priorities are.
As a result, the forces for a weakening U.S. economy remain in place. Because of its current account deficit, the U.S. is dependent on daily inflows of about $3 billion every single business day; in a slowing economy, a severe current account deficit may cause a currency to plummet. Some say the dollar has fallen enough and that the rate at which the current account deficit is worsening is improving. As the dollar is weakening, the current account may indeed get some temporary relief; but such relief may be of little help to the currency if primarily driven by a weakening domestic economy. The boost in exports may not be able to offset the reduced attractiveness of the domestic economy to investors.
Does this guarantee that the U.S. dollar will continue to fall? Of course not; even if the problems worsen, as we expect, a technical bounce can not be ruled out; if that bounce was to last a couple of months, the pundits will once again tout the cyclicality of exchange rates. However, we are not faced with mere cycles; the policies and forces in place have, in our assessment, caused severe and long-lasting damage to the U.S. dollar; further, we do not see any policies on the horizon that would revert this trend on a sustainable basis.
Having said that, central banks in other countries are by no means eager to see their currencies rise against the greenback. Asian economies with their focus on exporting consumer goods to the U.S. are particularly vulnerable to a rise in their currencies; not surprisingly, these countries have so far fought successfully to keep their currencies weak. There is a lot of talk about the speculative potential in these currencies. In our assessment, these currencies do not qualify as "hard currencies" because we do not trust that central banks there will not engage in irrational policies as they try to maintain sales to American consumers in light of a slowing U.S. economy and upward pressure on their currencies. Any momentum may well come from China as it tries to cool down its economy; at this stage, it tries to reign in credit expansion through a patchwork of regulation, when indeed a stronger Chinese yuan may well be one of the more effective tools to induce a domestic slowdown; in our assessment, any such move will come in small steps, and unlikely before the summer 2008 Olympics.
Canada and Australia, as resource based economies, have benefited from U.S. and Asian efforts to overproduce at any cost. Australia has a significant current account deficit itself and its currency may be vulnerable in a slowdown; because of the high yield the currency provides, the currency has been a welcome destination by speculators and is likely continue to experience elevated volatility. In Canada, interest rates were recently lowered by its central banks to help exporters that are highly dependent on serving the U.S. While Canada is thus one of the first Western central banks to yield to the pressures caused by a strong currency, the underlying Canadian economy remains strong; while the Canadian dollar is no longer severely under-valued as it was a year ago, relative to the U.S. dollar it continues to be attractive. At least that's our humble opinion: given the choice of holding U.S. or Canadian dollar, we favor the Canadian dollar.
In the past, we have called the euro the anchor of stability. This status has not changed, as European Central Bank (ECB) president Trichet has made it clear that while they will provide sufficient liquidity to allow credit markets to function, they have no immediate need to lower interest rates. The ECB can afford to have this hawkish view as the credit market problems are imported from the U.S, and the underlying economies in Europe are - for the most part - in good shape. There has been a surprising absence of political meddling with ECB policy due to the strong euro; there certainly have been some complaints by politicians, but very little given burden European exporters are facing. This may well be because larger companies in Europe have long-term hedges in place as exchange rate volatility is not a new phenomenon to them. As these hedges run out, we will have to carefully monitor how political pressure increases on the ECB, and how the ECB will react. Trichet believes the European economies are reasonably well sheltered from a U.S. slowdown, partially because of a strong intra-European market; partially because European exports tend to be more higher margin products. While we are not as optimistic as Trichet, understanding his thinking helps us in forecasting ECB behavior.
We manage the Merk Hard Currency Fund, a fund that seeks to profit from a potential decline in the dollar. We provide exposure to a basket of hard currencies without investing in equities; we also try to minimize interest risk.
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