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It wasn't that many months ago that pundits were tripping over one another in a mad rush to call the end of the U.S. dollar's multi-decade run as the world's reserve currency. As 2009 wore on -- and especially in the year's second half -- the greenback's swoon continued, with the U.S. Dollar Index threatening to match its all-time lows plumbed in early 2008. Traders seized on any bit of news or rumor, no matter how dubious the source, to pile on the beleaguered currency. Amid the currency market's bias against the dollar, calls increased for America's paper to finally be replaced as the global reserve currency, even if those making thee calls could not agree on what would (or even could) replace it.
Yet here we are in early 2010--and many of these same folks can't seem to get enough of the U.S. dollar. Commentators have greeted the greenback's resurgence with a mixture of amazement, curiosity, fear and scorn. One particularly humorous (but accurate) post a few days ago by one Michael Schuman on a Time magazine on-line blog entitled, "It's Alive!" summed up the incredulous views of many:
"The U.S. dollar was supposed to be at the end of its rope. Kicking the bucket. A dying symbol of a dying empire. Well, maybe not. The dollar continues to defy gloom-and-doom predictions. After a swoon last year, the dollar is again enjoying a major rally. The U.S. dollar index, which measures the greenback's value against other major currencies, is just off an eight-month high. Like the slasher in a cheesy horror flick, the dollar keeps coming back for another go, just when you least expect it..."
America's own gargantuan woes aren't much less worth worrying about than those in other locales. Yet currency traders are pretty much ignoring them. As we read in a recent issue of the long-running Australian newsletter The Privateer, "In two hits about seven weeks apart, the U.S. government has given itself permission to borrow and spend almost $2.2 TRILLION to tide themselves over the year of 2010. Any other nation which had done this would have seen their interest rates blow out and their currency plummet..."
Of course, such has not happened to the U.S.; even the Treasury market has settled down in recent days, with the yield on the 10-year note fluttering back down toward 3.6% from a recent high of over 3.8%. That America's fiat currency and its debt instruments are doing so well lately reveals that powerful forces are at work which we believe will -- over the next several months -- drive the dollar far higher.
Some of the reasons for this have to do with the marketplace's current fixation on problems elsewhere. Money flows will also play a part in the dollar's continued cyclical rally. And--depending on just how much the problems in Europe spread--policymakers there might succeed not only in propping up weak countries for a while, but diminishing the international allure of the euro as a consequence.
Let's spend a few minutes going down this list.
LESS FLIES ON THE DOLLAR "PILE"
There are precious few commentators on the CNBC financial and game show network worth taking seriously. One of them is Rick Santelli, the network's regular presence covering currency and debt markets. Faced recently with the paradoxical question of why it is that traders want U.S. paper amid a whole world of exploding debts and deficits--with the U.S. in nominal terms racking up more than anyone--Santelli quipped, "It's only because there's more flies on the other piles around us." Such is the market's perception, in any case. And, given the fact that the dollar had been beaten up and shorted for so long, the path of least resistance for it now is up.
Keep in mind that the dollar had bottomed before most of the current problems in foreign locales manifested themselves (due chiefly to the carry trade being stretched so far, a subject we'll discuss further along.) So, the buck does not depend solely on its current status of being "less bad" than other major (and a few minor) currencies for its stronger demand. Those other troubles--and, we feel, those still to come--have, though, served to give the greenback an even stronger push higher than we might otherwise have seen.
Many had warned that 2010 would see the previous fears over the solvency of the banking system and markets morph into concerns about the ability of governments themselves to service (and roll over) their debts. A transition of sorts on the way to this was the brief (so far) episode concerning Dubai, where an effectively quasi-governmental, but private, entity was faced with the inability to pay and refinance debt. Things have been quiet there of late; but some suggest we have not heard the last of this initial quake.
More recently, the concerns have been focused on both of the world's other major currencies: the euro and yen.
Where the former is concerned, policymakers at the European Central Bank are in a "damned if they do, and damned if they don't" dilemma. For Greece to be able to roll over a good chunk of debt that is due in the coming weeks, that country will need some help. What the markets are keen to see is what form that help will be in. Many fear that anything resembling an ECB or European-wide bailout will merely set a precedent that countries which have most violated the Maastricht Treaty's guidelines on their public finances won't suffer for it, but will be bailed out. It has appropriately been suggested that this would almost immediately invite speculative attacks on other of the so-called European "PIIGS": Portugal, Italy, Ireland, (Greece) and Spain. The last of these--a far larger potential problem than is Greece, and with an economy several times its size--will likely be the next big headache in the eurozone.
Japan has been fortunate, in a strange way, that it was long ago the first major nation to incrementally move private debts that could not be easily liquidated onto the public balance (or imbalance!) sheet. It's been doing so for two decades since its twin bubbles--in stocks and real estate--started to collapse. As has been the case more recently with the U.S. dollar, that so many yen were available at very low cost invited its use as a funding, or carry-trade, currency. Thus, markets have no more incentive right now to "trash" the yen by dumping it any more than, say, the Chinese would do well to dump dollars. Indeed, both those currencies have been useful to the markets as well as even other governments to maintain liquidity.
But Japan has been slowly using its one big advantage over other debtor nations: its ability to self-fund its deficits. That nation's aging has caught up with it; indeed, Japan's demographic time bomb has been warned of for some time. Not only is there less ability on the Japanese people's part to plow savings into their government's debt to help cover it; now, more older Japanese citizens will be drawing retirement checks. So, for the first time in the modern era, Japan will be having to raise significant amounts of money from outside its borders. (And it's even worse than this: as the Financial Times reported back in its Dec. 9 issue, debt issuance by Japan in the current fiscal year will exceed tax revenues for the first time since 1946.)
The trouble is, Japan can barely afford the paltry long-term interest rates it's paying present bondholders (the yields currently on 10-year Japanese bonds were around 1.3%, compared to 3.2% for euro-denominated and 3.6% for dollar-denominated debt.) Standard and Poor's has already dinged Japan's credit rating, by moving it from stable to negative. Were it to eventually downgrade Japan, funding costs would surge higher.
Fears are twofold. First, as investors outside Japan demand higher rates, that will push the country's financial position into real crisis. Second, it appears inevitable down the road that rising rates on Japan's long-term debt will serve to push (or pull) up yields elsewhere, exacerbating everybody's problems.
Though it probably should be, Japan is not foremost in the markets' minds. The euro and--most recently--the U.K. are in the majority of currency traders' crosshairs right now. Sterling has in recent days suffered one of its biggest attacks since the speculator George Soros famously knocked it out of the then-exchange rate mechanism back nearly 20 years ago.
The U.K.'s public debt and funding needs are proportional to those of Japan. Among major governments, those two have the highest debt-to-GDP levels in the world. But the pound's recent history has been far more "checkered" than that of the yen. For this and other reasons, the U.K. has for some years now generally sported the highest yields on long-term debt of any major country (right now, a sliver over 4% for 10-year paper.) That has made even more dicey the U.K.'s present ability to service debt without the Bank of England maintaining its own monetization program. The prospect that it will have to continue to do so while the European Central Bank and the Federal Reserve supposedly wind down their respective "quantitative easing" measures has helped weaken the pound. And adding to the damage is the environment engendered by a particularly nasty and close election contest.
America's turn in the currency markets' dock will come again. But for the time being, the dollar is viewed as the least ugly of a whole bunch of ugly ducklings.
REVERSAL, REPATRIATION...EVEN A Y2K-STYLE SURGE?
Recently, strategists at Morgan Stanley boosted their 2010 dollar forecast. They now call for the greenback to climb to the $1.24 area against the euro by year-end, improved from a previous estimate of $1.32 (which the dollar is only a Spanish hiccup away from right now, anyway.) Their target of $1.49 to the British pound has already been met. Lastly, Morgan's folks expect the dollar to climb to the 109 yen level from approximately 90 now.
While we only read the headline involved and not any details, we can make an educated guess as to why Morgan (and some others) think the dollar's run has much farther to go. The troubles elsewhere in the world are only one reason.
Those troubles will also be catalysts to increase global money flows in the greenback's favor. We'll give just one example of how this will play out, where it concerns the significant portion of the $1 TRILLION plus in Corporate America's cash coffers that are presently being held outside the country in other lands (and currencies.)
Until now, chief financial officers have looked pretty smart in keeping money outside the country, benefiting in this and other ways not that long ago from the dollar's decline. But now that the greenback is rising, it isn't so smart. Dollars will need to be repurchased, if they aren't being already. In addition, among the threats from Washington are to punish those corporations that keep money outside the U.S. So, the impetus is increased to repatriate some of this money.
Individual investors may also do some repatriating of their own, especially if--as we still strongly suspect--the global economy sickens anew. It's been well-chronicled that U.S. retail investors were A.W.O.L. from late 2009's bullish run on Wall Street here, instead favoring fixed income and emerging market investments. As the dollar's rise continues, it will hurt the performance of non-U.S. investments. Especially if the global economy turns sour--and, thus, emerging market funds disproportionately so, as always-- it might not be long before retail investors decide that "There's no place like home."
Added to all of the above is the fuel already in the dollar's tank via the need some will have to reverse dollar-enabled bets on other assets. At the recent World Economic Forum in Davos, Switzerland, Zhu Min, the Deputy Governor of the People's Bank of China, voiced his biggest concern over 2010. "To me, the big risk this year is the dollar carry trade," he said. "It is a massive issue. Estimates are that the dollar carry trade is $1,500 billion ($1.5 trillion)--which is much bigger than Japan's carry trade was." Some have argued that Mr. Zhu's numbers are exaggerated; yet even if it's true that the number is half his, that's still a big pile of money that could swing the other way.
And bear in mind that--especially here--momentum may well lead to an even dramatic move of the dollar rally feeding on itself. Currency traders follow money flows and technical indicators; and for the greenback, everything is flashing its color: green. As we suggested recently, the U.S. Dollar Index has been consolidating nicely in the area either side of 80.5. As you also see in the accompanying chart from StockCharts.com, the index's 50-day moving average recently turned above its 200-day moving average, a significant bullish indicator. Further, you can see here as well that the long-running decline in that longer-term moving average is flattening; and as it turns upward as well, that will be one more technical argument that will have tipped the ledger even more decisively in the buck's favor.
We have suggested on several occasions of late that one of the major non-U.S. holders of dollar assets, China, has an interest in seeing the greenback rise. As we cited several weeks ago, an investment strategist at China Investment Corporation--the big sovereign wealth fund--was "talking his book" in openly suggesting not only his fund's belief that the dollar will rise, but that China has a say in the matter, as a big owner of dollar assets specifically, and the owner of the world's largest reserves generally. That strategist, Peng Junming, added his view of dark days ahead for the yen, which would lose much of its future carry trade "business" to the dollar.
Flows in favor of the dollar will also be increased if we are correct in our assessment that any surprises to come in the coming months for the economy and markets will be of the nasty variety. As we have repeated endlessly of late, never forget that--at least at this present time--BAD news for the economy and financial structure equates to GOOD news for the dollar, as investors view the world's reserve currency as the ultimate safe haven. As we pen in our current essay entitled "Safe Havens Through the Looking Glass," it won't always be so. But that's the reality these days, as the markets proved in late 2008 and, more modestly, only a few weeks ago.
In a broad sense--and, really, encapsulating pretty much all of the preceding--the dollar's rise and its potential to rise further are just starting to remind us of the year 1999. Back then, as we recapped in the January issue, pretty much the whole world wanted to park its dough in dollar assets in case the Y2K issue ended up being a big problem. The currency, stock market and bonds all enjoyed great (if, in the end, fleeting for stocks) days. It will be interesting to watch the current nascent flight to "safety" as it plays out, and see if in the end it rivals the massive and broad-based move into dollar assets of 1999, as investors now flee sovereign risk elsewhere.
THE ONLY BIG GAME IN TOWN
In the end, we must remember that the U.S. has, by volume, the dominant currency in the world, and the largest and most liquid markets for virtually all manner of financial assets. During times of trouble, traders are accustomed to seeking out the dollar and its markets as a refuge.
The euro was once thought to be a serious rival; and who knows, some day it still may be. But apart from the previously-described troubles in the eurozone, there is another prospective development that could greatly enhance the U.S. dollar's existing competitive edge.
Even more so than in America, there is currently a wholesale rebellion against markets and, in particular, "speculators" in Europe. From Greece to Germany and in between, the current headaches are being conveniently blamed, in part, on (as John Dizard characterized it in his February 13-14 Financial Times column), "...shifty rich people who don't even live there." He went on to suggest that, "...sooner rather than later, European officialdom will impose higher taxes, credit restrictions and transactions barriers aimed at global macro traders...leading to exchange controls in everything but name."
The almost certain outcome of this would be to make even more so the U.S. dollar into the only deep, liquid and accessible currency.
We've been asked a few times lately what, if anything, could change our view that the dollar's cyclical run will continue for some time. The answer is that we would need to see convincing evidence that all the "green shoots" ballyhooed last year are for real; that, soon, credit creation for consumers and small businesses will ramp up, 150,000+ new jobs would be created each month, housing would really turn around, etc. Fears over commercial real estate and some 3,000 banks correspondingly being in trouble must turn out to be unfounded. Oh, and China will need to maintain its torrid pace of growth. And fears that England, Japan, Greece, Dubai and the others can't service their debts will have to go away. In short, the notion that much of the world has left all of the 2008-early 2009 troubles behind it--and that there are no remaining dangers of any kind of a repeat--will need to be true.
We think you know where we stand on all this.