Currencies: Dead Cats and Yapping Dogs

by: Ray Hendon

There are times of crises when the old order appears to fail.  Many cherished relationships and institutions seem upside down: the dollar becomes the peso of the world,  and nations long defined by underachievement and bumbling economies, have taken off with soaring growth and balance of payments surpluses. Models of fiscal discipline and booming exports, countries in Latin America, south east Asia and even Russia’s former vassals in eastern Europe, have become engines of growth.

I frequently read opinions that America of the 21st Century has become Rome of the Fourth, with a crumbling financial system, beset from all sides with barbarians pushing across the borders.  The dollar is down, and it will stay that way, they say.  The end of the old order is at hand!

The recent recovery of the dollar in international markets has given the naysayers a temporary pause, but they remain firm in the belief that this recovery is an illusion—a dead cat bounce, in the vernacular of the trading community.

There has always been a certain amount of yapping in the background of the financial world—the doomsayers will have their say.  Their comments are usually brushed off without much credence.  What makes it different this time, though,  is that the financial instability throughout the world  has discombobulated many investors;  they can’t tell up from down.  None of their cherished principles are holding up, and the volume and certainty one hears so forcibly expostulated gives even the firmest believers in the old order, reason to listen.  After all, with such a dramatic change still pulsing through the world financial system, who can we listen to?  Who can we trust?

I step into this fray reluctantly and without the bravado of certainty that encompasses much of what is said.  I don’t pretend to know when the dollar will peak—it may be days, it may be years.  But I do have an opinion on the subject, and mine is different;  I’m putting my bets on the upside.  The dollar has fallen so far that our goods are now becoming bargains for the rest of the world.  I think the dollar has turned the corner. 

If this proposition is true, then carry traders must adapt.  In my article of last week ("Carrying the Dollar Upstream"), I made this case—suggesting bundles of currencies to help balance a carry trade portfolio, and an orientation to pegged currencies to combat a rising dollar.  I mentioned the paucity of bundled currencies for now, but voiced the belief that more would be coming down the line.

My article was published on August 13th; on the 14th I receive an email from Deutsche Bank that they are now offering a bundle of their own.  This is through their currency trading platform, dbFX, and it was mentioned, not to pump up the product, but as a suggestion of how valuable their research could be to those who use their platform.  Not to argue with their supposition, but to me, the news took on a different cast.  To my knowledge, this is only the second old-line trading platform to offer a prepackaged bundle of currencies with something of a strategy behind it.  And, given the reputation and size of Deutsche Bank, it carries a gravitas that younger and smaller firms lack.

The specifics of their bundle are interesting, and is somewhat in accordance with my own research for suitable trading pairs.  The package consists of six currencies—three long and three short.  The long currencies are the U.S. dollar, the Mexican peso and the Hong Kong dollar.  They  short the Czech koruna, the Chilean peso and the South Korean won.  You can read their press piece here.  They provide a good rationale for their choices.

In the currency trading world they call this a flat carry.  The owner is hopefully left with the interest earned on the pairs, with perhaps a profit on the valuations.  But it is the interest earnings that are its attraction—that’s why they call it the carry trade. 

You can’t duplicate this package with ETFs --not exactly, anyway.  You can go long on the dollar with PowerShares’ Dollar Long ETF (NYSEARCA:UUP).  And, you can go long with the Mexican peso with their ETF (NYSEARCA:FXM).  Hong Kong is more difficult.  I don’t know of a single currency ETF or ETN that offers the Hong Kong dollar.  You can get it in a package from Barclays GEMS index (NYSEARCA:JEM), that I covered last week.  But, you pick up fourteen additional exposures, all long, in the process.

As far as shorting the Chilean peso, the Czech koruna and the South Korean won,  good luck outside a conventional currency trading platform.  These are not widely traded currencies, especially the peso and koruna, so I wouldn’t be looking for them to show up as single currency ETFs in the near future.

But, the Deutsche Bank recommendations still provide value.  Their analysis is, typically, well thought out.  They may be wrong, of course, but I would generally give them the benefit of the doubt on this judgment.

For now, let’s take it as their opinion and look elsewhere for additional information in order to build an optimistic carry trade portfolio.  One suggestion I found is from the head of the PIMCO emerging markets bond fund, Mr. Michael Gomez, Executive VP of PIMCO, portfolio manager and Co-Head of the Emerging Markets portfolio management team.  Mr. Gomez has good practical experience with Goldman Sachs and as a former advisor to the Columbian Minister of Finance and Public Credit.  His specialty is in emerging market bonds, but he must be acutely aware of the currency risks when choosing an EM bond portfolio.  

I must mention that earlier in his commentary Mr. Gomez listed the U.S. dollar as a bad bet, with its terrible balance of payments position and domestic budget deficit.  No one could argue with that take, but in the coming battle for world sales, the U.S. will be competing with other nations that are battling the same demons we face -- high inflation, falling trade and high unemployment-- but they face them with much higher currency prices.  I like our odds.

In his August commentary on the PIMCO website, Mr. Gomez instructs us to:

Concentrate investments in the economies with credible policy anchors and balance sheets strong enough to help them weather the storm. At the top of this list is Brazil, with local bonds a particularly attractive long-run investment. Five-year bond yields are close to 14% in Brazil, with inflation running close to 6%. The Central Bank has cemented its credibility by raising rates aggressively to ensure inflation returns to target. This provides investors a unique opportunity to receive high interest rates in investment grade credit, with credible monetary policy, prudent fiscal policy, solid balance of payments dynamics and political calm (compare this to the U.S. case above). Asian FX (particularly Singapore dollars and Chinese yuan) also offer good risk-reward ratios in this environment, as balance sheets are in many ways the mirror image of the U.S.

Although he is writing primarily about bond investing, the implications for currency holdings are also clear.  He mentions Brazil’s strong position of international reserves, just less than $200 billion in February of this year—see the chart below.

The next chart (click to enlarge) shows the Brazilian real’s  price in U.S. dollars from Jan, 2000, through early 2008.  Note the plummet from early 2000 when the emerging markets financial crises was in its worst throes.  This history is interesting to study.

It developed over a period of years, and almost all emerging nations took it on the chin.  They were all poorly financed, using mostly short term U.S. dollar denominated debt, had poor fiscal policies, and balance of payments deficits.  For Brazil, the beginning of the end came in late 1999 when Russia defaulted on its debt.  That very day international capital flight from Brazil became a torrent.  They were forced to let the real float; you can see the damage.  You can also see how they recovered since then.

In his last sentence Mr. Gomez also recommends the Chinese Yuan and Singapore dollar as having good potential for growth, but I don’t think their interest rates are particularly attractive for U.S. carry trade investors.  The Chinese limit U.S. dollar deposits to around 2% interest.  Singapore is a little better.  They make it easy to open deposit accounts there, but the commercial short-term interest rate is 3.9%.  Not attractive for the carry trade—both  currencies would be strictly value plays.

To summarize the main points,  if you believe that the dollar is turned around, here are some suggestions for structuring a carry trade portfolio:

  • Long on the Mexican Peso (FXM)
  • Long on the Hong Kong dollar
  • Long on the Brazilian real (NYSEARCA:BZF)

If you are a brave soul, and are willing to go short, the suggestions are: the Czech koruna, the Chilean peso, the South Korean won, the Hungarian forint and the Romanian lei. 

A prudent investor will scrutinize these recommendations with the greatest care and a strong skepticism.  I do not recommend any foreign currency holding for my regular clients.  It is something I do, knowing the risks are high.  But, I am doing it in a carry trade environment (except for UUP), and have no qualms on bailing at the slightest hint of disorder.  If interest rates rise in the U.S., as many expect them to, it may be that within a few years we will again offer an interest rate above inflation.  But, that isn’t the case for now, so I am content to earn higher rates in the currencies I own and take the risks they bring.  These are not buy-and-hold investments.  They are buy-and-watch- closely  investments.  Comfort and international currencies do not go together.

Disclosure: Author holds positions in FXM, BZF, JEM and UUP.

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