Currencies | Oct 21 2009
By Greg Peel
Currency speculators across the globe are short the US dollar, to a greater extent than ever before this decade. But as the following graph shows, speculators are not going short dollars at decade highs in the dollar index, they are building shorts near decade lows. Indeed, near all-time lows.
The world is betting on the demise of the US dollar, a belief held based on the sheer size of the US twin deficits – current account (foreign reserves) and fiscal (net government spending) – which are greater on a percentage of GDP basis than any time since the Second World War. The simple reality is that the global financial crisis, rooted in the US, has hit the US hard, to the point where the US economy is not considered able to recover quickly enough to support the level of emergency fiscal and monetary stimulus. Economies elsewhere in the world, particularly in emerging markets, have recovered far more quickly and are already returning to strong growth.
While the developed world economies of Europe and Japan also have their post-GFC problems, relativities with the US have sent the dollar southward at the expense of the euro and yen. I say expense, because Europe and Japan are exporter economies which are hampered by a stronger local currency. In the meantime, competitor exporter China has its currency pegged in a range to the US dollar and thus is enjoying more competitive export prices. China, too, is worried about the US dollar, given the extent of its foreign reserves held in dollar assets, but China is in no rush to revalue its currency and risk derailing its economic locomotive.
It is a long-proven reality of financial markets that when the whole world sets itself in one direction, markets are most likely to respond in the other direction. This is the “contrarian” rule. In the case of the US dollar, if the whole world becomes short the US dollar, who is left to sell it lower? And if the USD doesn’t actually go lower as expected, how long will the world hold on before there is a mad rush to cover short positions?
While one struggles to find any disagreement from global economists that the US dollar must weaken in the longer term horizon, expectations are building for a shorter term dollar bounce. But just as contrarians have long been expecting a pull-back in the global stock market rally based on “overbought” opinions, and not yet been rewarded with one, contrarians have also been expecting a dollar bounce for a while now, but are still waiting. And the US dollar simply continues to drift lower.
As the dollar falls, the stock market rises, and on the odd occasion when the dollar ticks up in a day’s trade, the stock market falls. Hence, while stock market analysts may have given up on the stock market turning around by itself, they are now looking to the potential of a US dollar bounce as the catalyst for the long expected pull-back.
But what might make the dollar bounce, apart from the fact everyone is short? There seems little chance of the US suddenly reducing its deficits, the Fed is maintaining a near-zero interest rate policy for the foreseeable future, and recent US economic data have not been all that flash. There seems no natural catalyst for US dollar strength.
But remembering that exchange rates are merely ratios, there is every possible catalyst for US dollar strength as the flipside of forced currency weakness elsewhere on the globe.
On Monday the finance ministers and other officials of the European Monetary Union members (the subset of the European Union members which have adopted the euro as their currency) met in Luxembourg. All were in agreement that the strong euro – the result of a weak US dollar- was hurting the European export industry. Yesterday Reuters quoted the French finance minister, for one, as suggesting the Eurozone “wants and needs” a strong US dollar. A French presidential advisor went one step further and stated that the euro at US$1.50 would be a “disaster” for the European economy.
In July 2008, the euro hit US$1.60 – the highest it had been since its inception. But that was when the world thought the Credit Crisis was simply an American thing. By Christmas the euro was back at US$1.25, in recognition of what was by then considered a Global Financial Crisis. The euro has now climbed steadily back through 2009, by 20%. Last night the euro hit US$1.50 once more – the supposed critical level.
It is likely that currency markets are expecting European government and central bank officials to react beyond US$1.50 and start buying US dollars. Hence the euro failed to push through last night, and instead bounced back as the dollar strengthened when the US stock market fell. Yet it was still just a blip in the current overall trend.
Japan has the same problem. The yen has risen 10% against the dollar since April this year. Japanese officials, too, have implied the need to prevent too great a yen appreciation, suggesting there is also a level in which Japan will start buying dollars.
While these seem like excessive currency movements in such a short period of time – and they are – they pale into insignificance with the Brazilian real. That currency has appreciated 35% against the US dollar this year, threatening the spectacular growth of Brazil’s emerging economy. This week, Brazilian officials were forced to act.
The Brazilian finance minister announced on Monday that Tuesday would see the introduction of a 2% tax on foreign capital inflows into the Brazilian stock and bond markets. As the world has re-embraced risk assets since March this year, Brazil has been one major recipient of global investment. The country’s commodity wealth has attracted a rush of buyers for the likes of energy company Petrobras and diversified miner Vale, while the Brazilian central bank cash rate of 8.75% makes the Reserve Bank of Australia’s 3.25% seem piddling. Investors can borrow US dollars at near zero and invest in high-yield Brazilian bonds, or invest in a stock market which has risen 130% in twelve months.
That’s why the Brazilian real has been surging as the US dollar falls. And the Brazilian government, like its older world counterparts, is worried about Brazilian exports becoming uncompetitive. The 2% tax immediately forced the Brazilian stock market to fall 3%, but this is a small mercy in the scheme of things. Commentators suggest the tax will force foreign investors to trade Brazilian stocks only in US exchanges, through American Depository Receipt Listings. ADRs are denominated in US dollars.
Across the globe, exporter countries are worried about their currencies, and worried about bubbles building in their asset markets. But the irony here is that every country is in the same boat, be it Europe attempting to export machinery or Japan cars, or Brazil and Australia competing on iron ore. Everyone’s currency is going up – everyone is in the same boat.
Except China of course, given the renminbi is pegged to the US dollar. China is expected to announce annualised GDP growth of 9% tomorrow, which while recently driven by domestic economic growth will still reflect a competitive export economy.
All major economies across the globe, developed or emerging, agree that in order to avoid another GFC the world must move towards global balance. For the ledger to balance, the US must stop over-spending on credit and China must address its artificially low currency. Otherwise we’ll just eventually end up back where we started.
China intends to revalue its currency – very slowly. To do so suddenly would be to cause a burst of its economic bubble. On the other side of the coin, US Treasury Secretary Timothy Geithner said last week, on the announcement of America’s annual fiscal budget deficit level of US$1.4 trillion, that America must “live within its means” once the economy recovers. Seeing as how America has been in debt since the early seventies, such words are somewhat hollow.
So the rest of the world is caught between a rock and a hard place. The US dollar really should be allowed to devalue, as that is the mechanism for reining in conspicuous US consumption. But a weak US dollar is affecting export competitiveness and reducing export receipts in local currency terms, given the US dollar is the reserve currency of global trade. The rest of the world cannot afford to let their currencies appreciate too far, so the only thing to do is for governments to buy US dollars.
The question is, when?
Were governments across the globe to step in and collectively support the greenback, today’s record short dollar positions would be covered in a scramble. Were this to occur, the world would finally get the stock market pull-back it has been waiting for, probably violently. Commodity prices would tumble.
But it hasn’t happened yet.
