The Dollar and Asia: Time for a Reversal?

Is the worm turning, if ever so slightly, for the dollar? Regular readers will recall that last summer, Macro Man began to contemplate the notion that aggressive Fed easing would generate a "dollar down bubble." The view played out as well as possibly could have been expected, in both the currency and the commodity space; Macro Man's only regret is that he was hors de marche when the most impulsive breakdown in the dollar occurred. And yet he now finds himself less tactically bearish of the buck than he's been since August of last year.

Recent data from Europe suggests that some of the pain of tighter credit is starting to spread. While there is still no assurance that the ECB will act in the near or even medium term to cut rates, it seems clear that the endgame will be an ECB rate cut. That, combined with the nosebleed valuations of EUR/USD (and many of its closely correlated peers), makes dollar shorts less attractive at the moment. When when considers that Voldy and co. have been selling EUR/USD, there's even more reason for concern on dollar shorts.

An even more interesting dynamic is playing out in Asia. China has seen its trade surplus shrink markedly; part of this is seasonal, but part of it appears to be cyclical: China's export growth has fallen off, thanks in part to weak demand in the US, but import growth remains firm, no doubt partially due to a negative terms of trade shock. And part of that ToT shock is, in Macro Man's view, a direct result of the "commodity leg" of the dollar down bubble. And that is why Macro Man postulated that CBs could be trying to support the dollar against euros, rather than their usual euro buying.

Regardless, the dynamic in Asia seems to have changed. For most of the past several years, short USD/Asia has been a favoured "fundamental" dollar short, given the relative imbalances that Brad Setser has written so much about. However, a few people, most notably Stephen Jen of Morgan Stanley, are being to question this trade, at least tactically.

Given that China is shutting down next month for the Olympics (they need a few months to clear the air), one could argue that CBs will be less willing to tolerate the appreciation of their currencies without an ongoing growth driver.Whether that's true or not, there's pretty clearly been a change in market view on China. The 6 month NDF has put in its largest correction higher since the RMB floated in July 2005.

A broader Asian currency index, on the other hand, has shown little signs of such a substantial correction. While some are certainly well off their highs (KRW springs to mind), overall the recent hiccup is little more than a blip on the chart.

USD/JPY, on the other hand, is more interesting. Macro Man ran a little study to determine the historic scope of bear market rallies, wherein a bear market is defined as a negative 6 month change, and a 'bear market rally' is the difference between the spot rate at time t and the minimum of the last 6 months. The chart below shows the results; the current bear market rally in USD/JPY is the largest since early 2000 - a rally that marked a medium term low in the pair.

At this point, Macro Man isn't prepared to call an end to the dollar down bubble- after all, real policy rates in the US are laughably low. However, he finds himself more neutral than he's been in the better part of the year, and tactically his position against "stuff that moves" has edged towards the long side.

He's aware that he has a lot of company in wondering if the dollar is set to bounce, a lot of which has more conviction and, in all probability, bigger positions than him. For this reason he's allocating a pretty small risk budget to a "dollar bounce" trade. But as he looks around, he sees some interesting RV trades in the EM space: certain CBs (Bacen, CBT) are clearly worried about inflation and are/will soon be acting on those concerns. If Asia starts dropping the ball on inflation, perhaps a rotation out of Asia and into high carry EM is on the cards - particularly if equities continue to confound the bears and grind higher.

Comments

[arawak]

Your analysis is appreciated but I am always suspect of forecasts that are based largely on charts. History does not repeat itself in any fashion reliable enough to use as a direct investment tool. It's analogous to "timing the market" and it doesn't work.

The dollar is down for a number of reasons that are only going to compound with time. For starters, massive US debt that has attained critical mass (it essentially can not be reduced at this point -- hiking taxes would savage a fragile economy leading to less tax revenue). Foreign creditors are rightfully wary of shipping more cash our direction for treasuries that are highly liable to be worth less and less, in real terms, with each passing month.

Couple in our soon-to-be-incomprehen... reliance on oil and it's guaranteed bullish trend which can only cause harm to the USA and, well... the greenback does indeed look a little sickly.

[Kunst]

Loss of confidence in US treasuries as an investment will force interest rates up, strengthening the dollar but chilling the stock market. That in turn will make US stocks a bargain.

Longer-term, it's hard to find an optimistic scenario for the greenback, between massive debt and unsustainable oil consumption. Eventually, US incomes and standard of living have to be based on competitive advantage. The trade deficit clearly shows that it is currently a disadvantage. For some time now, we have been selling assets rather than production.

Keep in mind that it is not just the US that is being stressed by high energy and commodity prices. China and Japan have huge but not unlimited dollar reserves. Many other countries are not so blessed. As water flows downhill, the financial terrain is sloped -- increasingly steeply -- so that dollars will pile up in the oil-producing countries.

I expect the energy bubble to suck the life out of the US and world economies. Lower economic activity will counteract the energy/commodities bubble to some degree. Agriculture is the one bright spot for the US, as we are a huge exporter of food.

[dougnhi]

If the dollar bounces, it will not be because of any help from Helicopter Ben. Until the FED stops intentionally trashing the currency, the hope for the dollar is limited at best. If we want to defend the dollar, we should start by firing Bernanke. Hopefully, the bond market will start sending messages that will force this idiot to correct his ways and defend the dollar. That will put a dent in this outrageous inflation and commodities speculation we've been seeing. Personally, I can't see Helicopter Ben *ever* doing the right thing....he'll inflate until someone forceably removes him. Let's hope the next president (whoever that turns out to be) starts cleaning up the mess by throwing this bum out. Maybe then inflation and our dollar will begin to turn around.

[yank]

Doug:
I understand your frustration with Bernanke but the reality is he has little choice but to inflate us out of this mess that his predecessor created. It's all well and good for us to sit in the comfort of our living rooms and bitch about the price of gas and milk but the larger issue Ben is grappling with is this: we have the highest foreclosure rate in the USA since the 1930s. Unless house value depreciation is stopped we could experience what Japan did in the 1990s where avg house prices dropped 50%, net incomes plummeted, and unemployment skyrocketed. I don't think we want that, do we? Whether we like to admit it or not, over 50% of the net worth of an avg American is tied to his/her house value. And the value of the home in many cases determines the spending level of this consumer (equity financing). It's all related. And trust me, Bernake is much more terrified of deflation than he is of inflation. Deflation in Germany was what led to the collpase of the Weimar Republic and the arrival of Hitler.