Dollar Could Surprise in 2010

Guest Post by Oxford Analytica

Investors who continue to short the dollar in 2010 face considerable risk.

The dollar/euro rate has surged from a low of around 1.25 in early 2009 to over 1.50 today, almost regaining its 2008 peak and renewing speculation that the dollar is facing sustained devaluation. While this cannot be ruled out, and the dollar faces formidable short-term pressure, there are good reasons to expect a rally over the next six to nine months. Investors who continue to short the currency in 2010 face considerable risk.

Dollar cycle. The current round of dollar weakness follows a strong rally during the peak of the financial storm, in a well-rehearsed pattern of dollar cycles:

• The rally under former President Ronald Reagan from 1980 took the dollar up by as much as 40-60% (based on a weighted index that varies according to the currency basket used) before the Plaza Accord punctured the bubble in 1985-86.

• The ’strong dollar’ rally under former Treasury Secretary Robert Rubin (the ‘Rubin rally’) of 25-30% from the late 1990s up to 2002 came amid optimism over a strong US growth outlook.

The dollar cannot be seen as a one-way bet. Indeed its latest rally took it from 1.60 dollar/euro in mid-2008 to 1.25 in early 2009.

The euro. The euro is not a driver of the dollar. On the contrary, dollar sentiment drives the euro as European bonds are the main alternative to holdings in the liquid US bond market. The euro is rising on dollar flight, moving rapidly from around 1.25 in the crisis period of early 2009 to its present rate of 1.50. Its latest surge, and the threat of rising ECB interest rates, is problematic as the EU economy is still struggling to emerge from the global recession, with world trade down some 20% from peak.

Renminbi. On a strictly balance of payments basis, a candidate for revaluation against the dollar would be the renminbi. This confronts at least two problems:

• Renminbi assets. There is no foundation for substantial foreign holdings in Chinese financial markets, so money inflows to China to sustain a renminbi rally would have nowhere to go, especially given frothy equity and property markets. Such a factor has kept the yen from becoming a more international currency.

• Policy. Any substantial revaluation in the renminbi is being blocked by China’s renewed tight control of the crawling peg. In the midst of last year’s crisis, and a sharp dollar rally, Beijing halted the renminbi’s slow appreciation against the dollar.

Now that the dollar is weakening against other units, China is enjoying a trade-weighted depreciation, prompting demands for a Chinese revaluation. These are likely to fall on deaf ears, considering the haemorrhaging in China’s export sector and the economy’s slide into deflation.

Oversold. In the short term, fear over a change in the dollar’s status and ECB talk of higher interest rates could push the dollar down and the euro higher still — perhaps to a new peak in the 1.60-1.70 dollar/euro range in late 2009 and early 2010. Yet such a trend would soon stall:

• The euro will likely have to reverse much of its gains to restart the EU economy.

• China is unlikely to seek faster renminbi appreciation. The balance of factors point to too many hazards and too few incentives in spite of unease about dollar neglect and talk of promoting alternatives to the dollar over the long run. Moreover, US policy will come under attack from Europe for dollar neglect, doing China’s job for it.

Outlook. If the US recovery picks up steam, helped by the weak dollar, while the EU economy suffers a double dip, the conditions for a new dollar rally should emerge. If global conditions look safer, led by a resurgent US economy, Japanese investors may also be back in foreign markets, weakening the yen. Tough rhetoric from the Fed may also hit the carry trade. While such a change in direction will probably have to wait until mid-2010, it could pick up considerable steam on the back of short covering in the dollar. These investors as well as those highly exposed to dollar-hedging assets such as gold would stand to lose.

Comments

[fleeing omega:]

US "recovery" is not so much helped by the weak dollar is it IS the weak dollar, the whole thing provided by new gov't debt, the printing presses, and lot of pigs with lipstick grunting "hooray!".

So in my view, any tendency toward recovery will be strongly correlated with a falling dollar, whereas any dollar rally (a very real possibility) will result from renewed instability and systemic deflation (indicating that it is still early to go long the inflation trade).

Oct 30 05:41 PM

[dingding:]

The US 'recovery' is a statistical mirage created by the US government spending money it does not have. So the US 'recovery' giving strength to the dollar is a good joke.

Oct 30 10:53 PM

[Jasper M:]

I am not surprised by the $ rally; I have been long UUP for Months.

Oct 30 11:19 PM

[Albertarocks:]

I don't think there's much doubt the dollar "could surprise". In fact, it's virtually guaranteed to "surprise" because last time I read a report on the bullish sentiment for the dollar, it showed that sentiment stood at 96% bearish. In my view, the fact that the markets have rallied for so long and on such suspicious volume activity... that is the real surprise. The market was only able to keep up such a sustained 8 month rally because of the FED's absolute refusal to support the dollar. That too should have been considered the true surprise. Why didn't the FED do a damned thing to prop up the buck? Because had they done so, the crash from the 2007 highs wouldn't have stopped where it did in March. It would still be going and the Dow would today be passing through somewhere near the 1500 level.

There are various reasons why the deflation camp are probably right, that we're going to see a pronounced rally in the dollar and a resulting drop in the markets for as long as the dollar is rallying. I have to agree with the author. There are pressures out there that suggest the dollar could indeed enjoy a surprisingly strong bounce. The author suggests that bounce could last perhaps as 6-9 months. That's definitely going to surprise, but if it does indeed rally for that length of time, we're looking at the very strong likelihood of the equities markets falling well into next spring, at least. It's virtually guaranteed because charts show conclusively that since 2006, and arguably 2003, the relationship between the dollar and the equity markets is firmly locked in an inverse relationship. Here's a chart I put together to prove that point:

stockcharts.com/h-sc/u...

Had the FED done the honorable thing all along (wait a second, I don't think that one's in their playbook) and had shown any respect or goodwill toward the foreign governments who bought the bonds on good faith, the dollar wouldn't have tanked in the first place. But then, in reality it's already lost 96% of its buying power since the FED was instituted, so why not just lose the final 4 percentage points as well and institute the One World Currency without further ado? Maybe that's exactly what they're discussing next week at the G-20 meetings. Let's hope and pray that demonic plan is not on the agenda.

Oct 31 01:00 AM

[Dave Wrixon:]

There is an inverse relationship between between currency and stock valuations in any market. Nothing new there. But what the numbskull analysts forget is that the total size of the cake can grow or shrink. If there is total loss of confidence in the US as a place for investment which looks highly probable you will have both falling stocks and a collapsing dollar. Last time around the US persuaded everyone that it was a safe haven. That is trick that is not going to work second time around.


On Oct 31 01:00 AM Albertarocks wrote:

> I don't think there's much doubt the dollar "could surprise". In
> fact, it's virtually guaranteed to "surprise" because last time I
> read a report on the bullish sentiment for the dollar, it showed
> that sentiment stood at 96% bearish. In my view, the fact that the
> markets have rallied for so long and on such suspicious volume activity...
> that is the real surprise. The market was only able to keep up such
> a sustained 8 month rally because of the FED's absolute refusal to
> support the dollar. That too should have been considered the true
> surprise. Why didn't the FED do a damned thing to prop up the buck?
> Because had they done so, the crash from the 2007 highs wouldn't
> have stopped where it did in March. It would still be going and
> the Dow would today be passing through somewhere near the 1500 level.
>
>
> There are various reasons why the deflation camp are probably right,
> that we're going to see a pronounced rally in the dollar and a resulting
> drop in the markets for as long as the dollar is rallying. I have
> to agree with the author. There are pressures out there that suggest
> the dollar could indeed enjoy a surprisingly strong bounce. The
> author suggests that bounce could last perhaps as 6-9 months. That's
> definitely going to surprise, but if it does indeed rally for that
> length of time, we're looking at the very strong likelihood of the
> equities markets falling well into next spring, at least. It's virtually
> guaranteed because charts show conclusively that since 2006, and
> arguably 2003, the relationship between the dollar and the equity
> markets is firmly locked in an inverse relationship. Here's a chart
> I put together to prove that point:
>
> stockcharts.com/h-sc/u...;p=W&yr=20&...
>
>
> Had the FED done the honorable thing all along (wait a second, I
> don't think that one's in their playbook) and had shown any respect
> or goodwill toward the foreign governments who bought the bonds on
> good faith, the dollar wouldn't have tanked in the first place.
> But then, in reality it's already lost 96% of its buying power since
> the FED was instituted, so why not just lose the final 4 percentage
> points as well and institute the One World Currency without further
> ado? Maybe that's exactly what they're discussing next week at the
> G-20 meetings. Let's hope and pray that demonic plan is not on the
> agenda.

Oct 31 06:50 AM

[Bull Run:]

2 points to consider; The Asian Zone is considering a currency for the area,( at meetings now on ) which will mean that all trade accounts will NO longer need the US dollar. Most Americans are still in denial, and believe the status quo will continue...well it won't. Most believe that to establish another trading currency would take years, well it won't. If fact it could take a weekend. All Asian countries have to do is agree; then each country according to it's economy's size buys into the new currency, hence from then on all accounts within the region are paid in this currency. The next region considering this is the middle east oil producing region. Again America sees their dollar, as if the world is forced to trade in US dollars; Yes it is convenient, and it's easy, because the system is all set up in US dollars, but it's also forces other world nations to pay for America's excesses, and now the world see advocating CHANGE. This means 2 things, 1) a collapse in the US dollar, and 2) a collapse in US equities. Foreign investors will pull money out of US stocks as they see the US dollar lose it's world currency status.. My point; watch for falling stocks, as a signal that large foreign (state) investors know of the coming change in world currency status. The world as we know it is coming to an END economically.

Oct 31 01:42 PM

[Old Trader:]

"Tough rhetoric from the Fed may also hit the carry trade."

Well, there's little to no doubt that the Fed has the art of "jawboning" down cold, but at some point, actions speak louder than words.

Having said that, I don't see the Fed launching a torpedo into the hull that's our economy....dead in the water and settling by the bow, by tightening any time soon.

Nov 01 01:41 AM

[Lok Sang Ho:]

The dollar has been in cycles of strength and weakness over the past decades. There has been no trending downward. The author is essentially correct, and those taking one way bets are exposing themselves to excessive risks. On the other hand, marked renewed strength of the $ can jeopardize the recovery. I am positive on this.

Nov 01 04:11 AM

[Cliff Wachtel:]

Excellent article and comments.

Despite the justified talk about the USD losing its premier reserve currency and trade benchmark status, it's critical to keep some perspective.
For the Near Term
A Near Term Stock Pullback Is Likely and Should Boost the USD
At present, the only short term reason to hold the USD is because it will benefit from the coming stock pullback and massive USD short unwinding. That, however, is likely to happen and could be a multi-month boost for the USD if the global economy lurches into decline for a double dip recession or even just period of stagnation.
USD due for rally over the coming months both because the USD itself is oversold and the global equities) are still way overvalued/overbought. Most of the time, world stock markets, which are usually best represented by the S&P 500, drive risk and safe haven asset prices. The dollar continues to behave like the #2 most safe haven currency after the Yen. Thus the sharper and more sustained the pullback, the higher and longer the USD rally.
When that rally peaks, then it will be time for those with short term time horizons to get out of USD assets as much as one can.

Even A Worst Case USD Collapse Unlikely for Many Years
Although there is plenty of talk about a sudden collapse in world demand for US debt, such talk strikes one as naïve. In a worst case scenario, which even the current US policy team is unlikely to allow, it's hard to imagine such an event happening for many years.
Why? Because most of the world still very much needs the US currency and economy and will continue to buy its debt and do whatever can be done to support the dollar out of pure self interest.
Virtually every major economy still holds a huge portion of their foreign exchange reserves, typically over half, in dollars. None wants to see those wiped out by a dollar collapse.
The export economies like Japan, the BRICs, OPEC countries, etc, do not want to see their own still massive USD reserves wiped out, nor their best customer. Thus they will do all they can to keep their best customer afloat,( just like US banks lent money to questionable debtors in order to keep their revenues flowing and people employed) at least until they can find other markets to fill the gap the US would leave. That will take time. Yes, they could well get hurt in the long term holding that debt, but leaders tend to deal with short term problems and leave longer term issues for later, or for their successors.

Long Term USD Trend Is Still Likely To Be Down
However, because there has been no change in the fundamental weaknesses of the USD, in the longer term i.e. over the coming years, there is no reason to believe at this time that the USD's downtrend will not resume.

Likely events that could yet save the USD:

1. Stock market pullback - likely. The USD still behaves as a safe haven currency for which demand rises in times of fear, especially given the extreme # of USD shorts that will need to buy dollars in order to exit their positions. As long as unemployment remains a problem, incomes, consumer spending and ability to repay debt will be weak. That means that GDP (70% is consumer spending), banking and housing, the sources of the current crisis, will remain troubled and likely lead stocks back down. It's unclear how long stocks will drop or stay down, but that's likely to be a matter of months, not many years.

2. Fed starts raising rates – very unlikely
Jobs and personal income are at the heart of the US recovery story, until these improve, there can be no meaningful US recovery. (though jobs growth has typically been a lagging indicator). Why? As noted above
• 70% of US GDP is consumer spending
• the banking and housing sectors, which led the US in and will lead it out of the current crisis, cannot recover unless Americans can pay their debts and spend enough to allow commercial real estate and debt to recover.
Low rates also keep the USD low and make US exports cheaper.
Finally, while the Fed has all the above incentive to keep rates low, it doesn't have strong reasons to raise rates in the near term. As noted above, large foreign holders of US dollars and debt may complain about the dollar, but they still need it and the US economy, so they will not walk away from US debt purchases, though they can and will do all they can to diversify more out of the dollar

Relative USD Strength—Possibly
Currencies trade in pairs, one valued against the other, so it's all relative. For example, a currency like the euro has had a huge run against the dollar, but not due to any major improvements in its own underlying fundamentals or interest rates. Rather, the USD was getting weaker and sentiment was turning sharply against it. This relativity can work in favor of the USD if another of its major crosses experiences new troubles, as long as the dollar doesn't also appear to be deteriorating.

Coordinated International Support – Likely
For reasons stated above, the US and the rest of the developed world will come together – fast, to lend support if the dollar really gets in trouble.

In sum, the likely USD trends are:
For the short term (coming weeks to months), up.
For the longer term, down – but not out, and with very tradable bounces.

Disclosure: long USD, UUP.

Nov 01 04:31 AM

[Formyx:]

Other countries have lived with perennial strong currencies and expanded their manufacturing base nevertheless. US manufacturing decline is symptomatic and it is not necessary that a devaluation alone will solve its ills.

I agree with the author that US$ is relatively undervalued with the exception of the Yuan and it is due for a rally. Further decline simply diminishes wealth without really providing any real fixes.

Nov 01 02:34 PM