Tuesday, September 15, 2009

The Elastic Band that is the Dollar

The dollar has fallen dramatically in recent months and it took a leg lower in the past week when increased liquidity after the summer holidays saw investors put their money into higher yielding currencies and metals. Despite the usual garb being published daily about the 'dollar being finished' and US debt spiraling out of control, there are some dangerous extremes developing in financial markets again and all the evidence points to financial markets once more being divorced from economic reality. A sharp reversal is inevitable, with the strength and severity of the reversal likely to be determined by the length of time it takes for markets to meaningfully 'correct' or pull back from these extreme levels. The longer it takes, then the more taut the elastic becomes and the more severe the reversal.

Let us look at the key events that lead me to this conclusion.

1) Gold prices.
Gold has risen sharply in the past 2 weeks, to over $1,000 an ounce for the first time since early 2008. Closer examination shows that this increase is not owing to any physical demand for the commodity but by speculative demand from money managers. Open interest hedge fund positions in gold at present, sees over 98% of hedge fund monies being net long on gold. This is an extraordinary extreme no matter how one looks at it and history tells us biased positions do not last forever and the greater the bias the greater the potential for a fall or collapse. Astute money managers should right now be reducing their exposure to gold for this reason, if for nothing else. Gold has the potential to retreat back to $800 or even less within no time, if some event triggers a sale. Central banks could deliberately bring about this collapse in the gold price, if they chose to do so, and there are several reasons why it might be in their economic interests to do so. Gold is traditionally used as a hedge against inflation but currently the globe has a deflationary problem and present and future US market rates do not hint at any looming inflationary issue for the world's largest economy. Gold prices are completely out of sync with interest rate expectations, which indicates gold prices are greatly inflated at current levels. Be warned!

2) Commodity Currencies.
The economic exaggeration currently reflected in equity prices is also evident in the price of commodity currencies. The Australian and New Zealand dollars are up over 40% against their US counterpart since March. The Canadian dollar is up over 20%. The global recovery story is only in its infancy and currency moves of the order of 40% are nonsensical, particularly for the Aussie and New Zealand dollars which represent economies with pretty dire current account deficits. This currency appreciation is based entirely on market speculation. 90% of non-commercial open interest in the Aussie dollar on September 1st was made up of speculative long positions. This represents an unsustainable extreme. It also demonstrates that Central banks have yet to grasp how speculative financial markets are free to derail competitive currency exchange. Central Banks have learned nothing from the recent market collapse and they continue to watch in silence as leveraged speculation in currencies leadings to a pronounced instability in exchange rate markets. The Australian and New Zealand dollars are due for sizeable corrections sooner or later, with both currencies currently punching well above their real exchange rate values.

3) Japanese Yen
What has been striking about the past 2 months in particular has been the replacement of the Japanese yen as the world's favourite funding currency (i.e. by speculative risk merchants) by the US dollar. What this means is that carry trades (speculative bets on higher yielding currencies) are now carried out using the US dollar (the dollar has a paltry 0-0.25% yield rate). 3 month libor rates currently have the dollar cheaper than the yen as a funding currency for the first time in many years. Carry trades, while attractive in some ways, are also very destructive to international trade competition as a large volume of speculative bets involving the same funding currency has the effect of depreciating the value of that funding currency, sometimes quite considerably. We also know that market scares lead to unwinding events that can result in a very sharp appreciation in the funding currency. We have seen this over many years with the yen and for now the dollar is the favoured vehicle for carry trades. At present almost 80% of open interest in the Japanese yen is net long, a quite remarkable position given we have had almost 6 months of unbroken growth in stock markets and sustained investment in riskier assets. It is safe to assume that the the bulk of the biased positioning in the yen right now is against the US dollar and any eventual return to impartial positioning, will result in a sharp reversal and a significant rise in USD/JPY. It is almost certain that interest rates will rise in the US before Japan and will rise much more quickly, something that will spark major capital flows from yen to dollars. The market will figure this one out eventuality, sooner rather than later, so look out for a sharp rise in USD/JPY before the end of this year.

What most speculative traders and daily analysts tend to ignore is purchasing power parity. It is almost incredulous that over a period of a few months an Australian can buy 40% more with their money than a US citizen can in US dollar terms. The prior Aussie rally to over 95 US cents can be discounted as that was driven exclusively by an asset bubble that burst last year. The differential standard of living in both the Australian and US jurisdictions has hardly changed in the past 6 months, yet the exchange rate markets that Central Banks have criminally refused to regulate now sees Australian citizens being able to buy 40% more than US citizens thanks to the unchecked greed of hedge fund managers. Of course we know that this is a false exchange rate, but at the same time it presents a fantastic opportunity for Australians to buy up US dollar denominated assets at a huge discount. Much the same can be said for Japanese and European (non-UK) investors. Because of the weak dollar exchange rate, it is an excellent time for Asian Banks to buy US Treasurys. European bonds are grossly over-priced for the Japanese and Chinese because of an inflated euro (which is over 20-25% overvalued) and the safer option in the longer run is to stick to buying US bills (forget what the doomsday merchants claim for the US, because we have learned in the past 2 years that the US is where it matters and that any negative contagion from there is global). Capital flows will eventually flow back into the US because of the gross imbalance in PPP and it will happen in a very significant way, once evidence of sustained economic recovery in the US is firmly established. The euro is currently benefiting in an environment that sees zero to minimal capital investment in the non-speculative 'real' economy,' but it will find itself out of favour when capital flows begin to pick up in earnest, quite simply because it is way too expensive to invest in the Eurozone. Even in good times, Eurozone economic growth is always a laggard behind the US and Asia.

Bob B - Sep 15, 2009