Every so often, an anecdote arises in the public domain signifying the public is all in or all out of a particular asset class, giving evidence that financial markets are at turning points. The most famous example may be BusinessWeek’s August 13, 1979 cover entitled "The Death of Equities."
Identifying such anecdotes is easy only in hindsight as such examples abound at extremes. However, one such anecdote may be the news last week that Brazilian supermodel, Gisele Bundchen, stipulated that she is to be paid in euros rather than dollars. It seems to have escaped the financial press – which has been lauding her decision, unsurprising given that the financial press is overwhelmingly male, and Ms. Bundchen is very much a female – that news of Ms. Bundchen’s trading ability may, in fact, signify a bottom in the dollar.
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It is my opinion that, indeed, last week may have been the bottom in the dollar, at least a bottom relative to other fiat currencies outside of Asia and the emerging economies. Perhaps it is not the ultimate bottom, as one might expect the dollar to bounce then retest the lows. However, I think in a year or two, we may look back and see that last week was the beginning of the bottoming process in the greenback.
In my career, I have never seen such a one-sided trade as short the dollar, so much so that last week I sold loonies for greenbacks.
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Apart from one or two commentators such as Dennis Gartman – publisher of the excellent daily Gartman Letter – and a few others on Bloomberg TV, virtually everyone is bearish or short the U.S. dollar, even more so than the nuttiness of the Talking Sock Puppet Companies of the Technology Bubble. At least then you had a cadre of killjoys telling you that what was occurring in technology at the end of the 1990s was utterly insane. Today, you still have a crush of respected investors telling you to sell the dollar, as the eminent Byron Wein did so on Bubblevision after the close on Monday.
Over time, I believe that as long as the emerging markets continue on their growth trajectories – no sure thing despite what the pundits tell you – the dollar will depreciate against those currencies. And that is a good thing because it will signify that hundreds of millions of people are being pulled into prosperity. But relative to the developed countries, the dollar is deeply over-sold and undervalued.
The values of currencies are determined by a number of factors, including sentiment, which I addressed above. The other factors are as follows:
Purchasing power parity: Recently, Credit Suisse (CS) estimated that purchasing power parity [PPP] of the euro is around $1.15. Today, the euro is trading about 25% above PPP. PPP for the Canadian dollar, the MoMo traders’ new favorite hard currency, is around $0.85, and thus, the loonie is also trading about 25% above PPP.
Political pressure: Last week, French President Nicolas Sarkozy stated that America risked “economic war” over the value of its dollar. For some time, European politicians have been complaining about the over-valuation of the euro. The political pressure will result in either the dollar being raised against the euro or the euro being lowered against the dollar, the latter being the most likely outcome, in my opinion.
Interest rate differentials: On the long end, there is not enough difference in interest rates to account for such a violent move over the past few years. Rates on the short end and the long end of the curve have been both higher and lower in America relative to its trading partners. Certainly, on the short end as of late, the Fed is in more of an easing mode than the rest of the world. However, that is due, in part, to forces that, I believe, are not unique to America, and will undermine economic growth elsewhere.
Mortgage and housing problems: The market is convinced the Fed must ease due to falling housing prices, and the imploding subprime market. However, home price appreciation in America actually lagged the majority of industrialized countries. Places like the U.K., Ireland, Spain, Canada, Australia, and South Africa experienced greater home price appreciation than America. Rising home prices was a global phenomenon, and falling prices will be too. And not only were many bad loans made outside of America, many of the crappiest traunches of the subprime-laden CDOs are held offshore by foreign banks and financial entities. Thus, the Fed may merely be a global leader in bringing down central bank benchmark rates.
Economic growth: I believe the U.S. is set for slower economic growth over the next several years. However, even though small structural changes have occurred in Europe, and growth should be faster going forward, the underlying long-term structural dynamics of the American economy are still stronger than most everywhere else in the developed world. Total productivity is higher, Americans work longer, labor markets are less regulated, and the country is still a magnet for the best and brightest. The Canadian economy, for example, is being driven by demand for raw materials. There have been no dramatic improvements in productivity that have altered the long-term structural dynamics of the economy (though perhaps the soaring loonie, and lower taxes will change that). And though there have been small changes in Germany and will be in France, and though the Eastern European countries will put pressure for structural change on the sclerotic economies of Western Europe (a fact that, I believe, is under-estimated), the underlying capacity for economic growth in America is still higher than in Europe, let alone Japan.
The trade deficit: The trade deficit is improving. In fact, after a decade, it looks like it may have bottomed and may be heading higher.
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Central bank selling: Central bank selling, I believe, will continue to be bearish for the dollar as the world’s central banks move away from dollars towards euros. However, the demise of the dollar is greatly exaggerated. No doubt the ratio of dollars held in reserve will continue to fall, since not only has the American government been enormously cavalier towards the sensibilities of foreign holders of its currency (amongst many, many other things), but as every Finance 101 student learns in the third class, diversification reduces your risk. Thus, the dollar’s composition will fall not from 65% of global currency reserves to 0%, but to 55% or 50% or 40%.
The dollar will play a significant role in the global monetary system for many decades to come. Also, simply because the central banks are on one side of a trade does not mean asset prices move in line with central bank transactions. After all, central banks have been selling gold from $260 all the way to $850, and will continue to do so when it shoots through $1500.
But that’s an issue for another time.
