Over recent weeks, extreme currency movements have been the main theme of financial markets. The currencies of the world’s two largest economies, the US dollar and the Japanese yen, have been beacons of light. In just the last three months or so, every other major currency has declined sharply against the dollar and the yen.
Deleveraging’ is the simple answer to why these two currencies are displaying unparalleled strength. However, we need to go much further back to really understand these recent violent currency moves. Firstly, let’s look at the extent of the dollar and yen’s appreciation against the world’s major currencies.
The dollar has been stronger against everything other than the yen, while the yen has been by far the strongest currency.
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Performance of various currencies against the US dollar over the past three months:
Performance of various currencies against the Japanese yen over the past three months:
Clearly, liquidity around the globe is rushing back to the source and sucking the life out of financial markets in the process. From an economic perspective, we can rationalize these moves on a short term basis but longer term, there does not appear to be any justification to support US dollar strength.
The US and Japan’s modern day economic relationship rose from the ashes of World War Two. The US helped rebuild Japan’s shattered economy and opened its vast consumer market to Japan’s fledging export industry. Over the next few decades, Japan’s economy turned into an industrial and export based powerhouse.
This has seen Japan turn into the largest creditor nation in the world, running massive trade and current account surpluses, year after year. Instead of reinvesting these savings and restructuring its domestic economy the savings have flowed to the US and all around the world.
For example, the Japanese are the largest holders of US treasuries, with investments totaling US$585 billion at the end of August. Elsewhere, the Hungarian Forint is collapsing as Japanese investors withdraw their support for that economy. The Japanese have invested heavily in Hungary and other smaller economies in recent years as these countries borrowed to speculate in housing (including Australia). That trade is now unraveling.
Put simply, a lack of productive investment opportunities at home, combined with low interest rates, saw Japan as a nation finance other investment opportunities around the world. Now the risk tide has turned and the Japanese are bringing their funds home at a rate of knots.
Given Japan’s creditor nation status, we believe a strong yen makes sense. This is the natural force of the market trying to push for an overhaul of the Japanese economy. Domestic consumption should rise and saving rates should fall. Cheaper imports will encourage this change in trend. Yen strength will see the export sector go into a sharp downturn, which should discourage further investment and additions to export based capacity.
While we can rationalize yen strength both from a short and long term perspective, US dollar strength is another matter entirely. US dollar strength is understandable in the short term, and we will explain why. But longer term, we doubt that such strength can be maintained.
The chart below shows the recent extraordinary strength of the greenback as measured by the US dollar index. The index measures the performance of the US dollar against a range of other currencies (see below).
What has caused this huge rally in the face of negative real interest rates and an economy in recession traditionally reasons to SELL a currency, not to buy?
The short term view is a matter of radically altered supply and demand dynamics. When the credit bubble was expanding, a hedge fund with, say US$1 billion of equity may have borrowed US$30 billion from a range of banks. This provided the investor with a US$31 billion investment war chest, or an extra $30 billion of purchasing power.
While much of these leveraged investments went into USD denominated mortgage backed CDOs, a huge amount of leveraged funds went into emerging markets, commodities etc. To affect this, the US dollar was sold and foreign currencies purchased. Use of such leverage was effectively a huge increase in the supply of dollars, without a corresponding increase in demand.
In addition, strong US consumption in recent years has also been a source of US dollar liquidity (supply). The US household sector borrowed heavily against appreciating house prices to artificially boost consumption. This led to a rise in imports, or put another way, an increase in the supply of US dollars that were then sold to buy imported goods.
These two dollar liquidity dynamics are now unwinding at a rapid pace. But of the two, we believe the former is the primary driver of recent US dollar strength.
This brings us to the question of whether such strength is sustainable. Returning to our earlier discussion, the modern day US dollar and US economic structure is a result of the outcome of world War Two.
Both Japan and Europe (with Germany being the strongest European economy) were rebuilt with American capital. With the US dollar established as the world’s reserve currency via the Bretton Woods Agreement of 1944, the long term structure of these respective economies was established. That is, Japan and Europe produced and saved, while the US consumed, courtesy of its huge reserves of capital (net creditor to the world) and newly installed issuer of the world’s reserve currency.
The US abandoned Bretton Woods in 1971 by going off the gold standard. At the time the US dollar was pegged to gold at US$35 an ounce and Europe was draining US gold reserves as the system swelled with excess dollars. US$35 gold was a bargain and the Europeans knew it. The US knew it too and couldn’t maintain the commitment to keep the dollar pegged to gold.
Having left the discipline of gold, credit was freely created and US debts began to pick-up considerably. That process has been building, on and off, for over three decades.
With the credit bubble now busted, the US dollar is rallying for the reasons we have explained. Even though the US dollar is still the world’s reserve currency, it has none of the attributes that established it as such more than 60 years ago. The US is no longer a creditor to the world. The rest of the world lends the US funds, not vice versa, more out of habit than anything else.
Japan has a strong currency because it is a creditor nation and it saves. This is not the case for the US. The US economy requires a far weaker currency to discourage consumption and encourage saving. Maybe that process can occur without a weak currency, but we are not convinced.
The US dollar should not be viewed simply through the US dollar index though. A great deal of US consumption and trade is transacted through Asia and China in particular. Since emerging from the Asian Crisis in the late 1990s, many export oriented Asian nations have held their currencies low against the US dollar in order to promote US consumption. They have achieved this by purchasing US dollar assets like treasuries and mortgage backed securities.
However, with their currencies continuing to fall against the US dollar and US consumption waning, the benefits of a weaker currency are no longer flowing through. These previous supporters of the greenback may begin rethinking their strategy. After all, buying US assets was a mercantilist approach that was done purely out of national self interest, not long term economic logic.
It is widely known that the US government will need to spend a huge amount of money over the next few years to offset the slowdown now occurring in the US. Estimates for next year’s budget deficit start at the trillion dollar mark. Can we really continue to expect Japan, China, Europe and the rest of Asia to go on financing this spending at low rates of interest? Our guess is that they will not.
For signs that foreigners are questioning the credit of the US government, we will continue watching the Treasury market. The chart below shows the 10-year US Treasury bond yield. In mid-October the yield spiked to over 4%, meaning bond prices fell. Prices then rallied but in recent days have eased back. The yield currently trades around 3.70%. We believe the bond market will be the next bubble to burst, the first leg of which will be signified by yields rising over 4.25%.
In summary, we are seeing major upheavals in the currency markets as a result of an unbalanced global economic system. The strength of the US dollar is signaling deflation, loud and clear. But we do not believe this will persist. After all, the process has only been in play for about three months. The Fed has an unlimited balance sheet with which to fight the forces of deflation. They are losing the battle at the moment, without doubt, but have not yet lost the war.