With the market now getting behind our weaker U.S. dollar call from July 2010, we want to review the various factors that led us to this call, and see what can be expected from the U.S. dollar going forward. The Dollar Index (DXY) has fallen 17% and the EUR/USD has risen 21% since we initiated our call.
Our initial USD sell recommendation came following the announcement from China that they would de-peg from the U.S. dollar and re-enter "flexibility" mode. We understand "flexibility" in the Yuan translates into both a stronger CNY and a weaker USD. In looking at the chart below we see that from 2005-2008, as USD/CNY fell, so did DXY. We concluded that the flexibility announced by China would translate into USD weakness. In part because in order to allow the CNY to strengthen the Chinese would have to buy less U.S. dollars, and also because the period of flexibility from 2005-2008 saw increased reserve diversification from Asian Central Banks and reserve managers, primarily into the SDR currencies of GBP, EUR and JPY. Secondary currencies that would also gain reserve status include the AUD and the CAD.
Click to enlarge
As the chart shows, the relationship between the DXY and USD/CNY collapsed once China re-pegged to the USD in 2008. The re-pegging forced China to buy the USD again to keep the CNY from strengthening. The USD was aided by significant capital flows into the USD following Lehman Brothers' collapse in a misguided "flight to quality." We concluded that this "flight to quality" would be unwound over the next 12 months and believe that we are now within 2% of that being taken out of the USD's value. This translates into the EUR/USD trading around 1.5000.
However as China remains in "flexibility" mode, we expect continued weakness in the USD, following in the path of CNY strength based on the causal relationship between CNY strength and DXY weakness. Interest rate differentials will now aid in USD weakness and EUR strength past the 1.5000 level. Currently the interest rate differential between Europe and the U.S. as seen through the two-year swap shows 157bps in the EURos favor. Europe remains hawkish while the U.S. remains dovish. We do not expect the Fed will allow interest rates in the U.S. to rise significantly for some time to come. Certainly not in 2011 and perhaps through 2012. There is no surprise that the Fed continually talks about U.S. housing and equity prices. Only through asset price inflation will the banking sector be able to unload the shadow inventory of foreclosed homes on their balance sheets without taking significant losses. In addition we believe the U.S. needs an extended time of low interest rates for the plethora of outstanding derivative contracts on U.S. bank balance sheets to roll off.
Asset price inflation is coming to the U.S., and is currently being experienced everywhere else globally. For this reason, every other country in the world is allowing their currency to strengthen against the USD. In part to dissipate inflation, but also to help unwind the imbalances caused by the overly strong USD from late 2008 and early 2010. It is important to note a few things: Traditionally, when a country faces tremendous financial damage, its currency weakens. This was seen in the Asian Crisis, when the currencies of Asia devalued, and in the Latin American Crisis when the same happened throughout Latin America. However when the U.S. faced a crisis, the USD strengthened. This did not help the U.S. economy in any way whatsoever. Not only was the U.S. in financial peril, but its export sector dried up. The stronger USD priced the U.S. out of significant export opportunities, much to the satisfaction of Europe, who saw the EUR/USD drop from 1.6000 to 1.1800, making European exports 26% cheaper than those in the U.S.
A weaker USD is good for the U.S. In fact we would argue it is encouraged by the U.S. administration. Only through a weaker USD is President Obama able to double U.S. exports over the next five years, an aim he set forth going into the G20 meetings last October and November. We have discussed numerous times the "Grand Bargain" hatched among the G20 in 2010 wherein all countries agreed to allow their currencies to strengthen at a measured pace versus the USD. This has been alluded to numerous times by practically every finance official in Asia, Latin America and Europe.
A weaker USD is here to stay. While the mistaken "flight to quality" is near to being unwound, the inflated devaluation of the USD is just beginning. A Fed on hold while other countries raise rates and inflation rises will be USD negative going forward. We expect the resulting weakness will continue to be measured and directional. The weaker USD will create jobs and inflate the economy. Although the U.S. administration, through the Fed and Treasury, will never admit it, calling for a stronger Yuan is equivalent to calling for a weaker USD, and as we see it, it is the only tool left in the U.S. toolbox.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.