Dollar Not Going Anywhere Soon - An Alternative to Sumitomo's Projection

Congratulations go to Sumitomo Bank's chief strategist, Daisuke Uno, who on the 15th made the announcement that the dollar would lose its reserve status within two years and subsequently fall to 50 yen, an especially bold call considering that the dollar is as unpopular as the Nikkei was popular in 1989.

Despite the newfound assertiveness of our Japanese friends, I find it hard to believe the increasingly urgent pronouncements on the dollar's demise. As a general principle, it's difficult to envision a currency which has been the lifeblood of the world's free economies for the previous 60 years going from considerable strength in 2008 to a second coming of the German mark by 2010. If we look at some of the fundamental shifts in the global economy, it's obvious that the U.S. faces no serious challenges to its economic dominance in the near future.

Sure, it is clear that many emerging economies are going to grow at a brisk pace and gain relative to the U.S. in an impressive fashion. But even with China growing at a sustained 9% a year, it will take almost 25 years for China's $2.2 trillion GDP to be in the range of the U.S.'s present $14.4 trillion GDP. This at least demonstrates that the U.S. dollar will play an important role in the global economy in the foreseeable future. Yet even this calculation assumes absurdly low U.S. rates of growth (sustained period of sub 1%) and an absurdly long period of high sustained Chinese growth (they've been growing at almost 10% for almost 2 decades).

Generally speaking, economies don't grow at 10% for decades at a time. Further, serious economic disruption within China will quickly bring into focus the problems of having a market economy within an authoritarian political structure. Russia is another potential time bomb considering its serious demographic problems, declining natural resource reserves, authoritarian government (wearing democratic clothes), and penchant for assertive nationalism. My point is that while emerging markets certainly have explosive potential, many of them also have serious issues that they will have to confront down the road. The U.S. will remain highly important to the global economy over the next five decades because of its stable political and legal systems, highly liquid and well regulated financial markets, and its brute size. Above all else, it's in the interest of countries like China and Russia to preserve the dollar's value considering the proportions of their reserves in dollar form.

Thus, any one expecting a collapse of the dollar might do well to extend their time horizon. I fully understand the lack of fiscal and monetary constraint in this country, but I also think the Fed learned its lesson about leaving rates too low for too long, the American consumer will save more and spend less, and there will be significant political pressure to reduce the deficit. Fears of hyperinflation will be for naught. Despite the bleak technical picture for the dollar index as a whole, I'd like to survey the dollar-yen relationship and provide an alternative thesis to Sumitomo's '50 yen' projection. First, let's take a look at the long-term chart of the USD/JPY relationship.

This chart gives the dollar yen rate from the mid 70s onward. You'd be surprised how hard it is to find reliable historical forex charts. The above graph ends in 2004, but idea for the past few years is relatively simple: the dollar gained to about 124 during the summer and has recently probed the 1994 lows in the zone between 86-100.

The interesting point here is that the yen has not even touched its 1994 highs of the 75-80 area. In contrast, it appears to be consolidating above that level. While far from certain, it's possible that we could be witnessing a massive double bottom in the dollar yen. Any move above 150 would probably indicate a new bull market in the dollar yen. A move below 76 would be quite bearish, yet I will make the argument that this is unlikely. Let's take a look at some weekly charts to discuss the present price action in relation to these significant long-term levels.

These charts run from 2007 to the present. The downtrend resistance line is clear in both charts. The challenge for the dollar is to break this trend line. If it were to do so, it would indicate significant bullishness. What's the chance of this happening? Well I think the most important aspect of these charts is the secondary bottom which occurred over the last few weeks. If the downtrend was fully in control, it would have made more sense for the recent bottom to fall below the bottom of Dec08/Jan09 of 87. Nevertheless, there was clear selling exhaustion above this level.

In addition, we see the clear rising sequential bottoms in the RSI. A third aspect to note is the tendency of the dollar-yen to hover near the trend line during this previous down leg. In the first two down legs, the price neared the trend line and plummeted. When a reversal is near, price tends to hug the trend line. While this is speculative, the solid shot down in Aug/Sep and the accompanying oversold condition may have provided the spark for a break of the line. Nevertheless, even if 87 support doesn't hold, we have room to the downside before we break that significant long-term 76 level. As a pair, the dollar-yen is an excellent trading vehicle because of the low correlation with the equity markets and the dollar's other pairs. Movements in these markets could contribute or detract from dollar-yen strength.

I will be the first person to sell the dollar yen if it breaks below that 87 level, yet I would suggest that when everyone is zigging it may be time to zag. Further, I'm not convinced that a break of 2007-2009 trend line will mean that the dollar yen has set a double bottom. It's possible it will simply set a double top near the 2007 high and fall further. Nevertheless, I believe that the Japanese economy has structural problems, especially demographic, which make its long-term prospects disconcerting. The dollar may not be the reserve currency in 20 years, but I think you'll be able to get more than 50 yen for it.

Comments

[dsr70]

Appropriately you identify the dichotomy of China's ostensibly free economy and authoritarian political structure. Ironically, I'd argue the USA increasingly represents the opposite. A free political system with an increasingly shackled economy. We are seeing regulation and taxation to degrees never before seen here. The legal climate, both because of govt mandates and tort, represents an ultimately fatal, in my opinion, recipe for our economy. This does not even take into account the abysmal state of education here. Add in the potential depegging of the yuan to the dollar and the 25 year scenario for China to pass our GDP is more like 15 years.

2009 Nov 30 10:57 PM