Sunday, November 09, 2008

Don’t Bet on the Dollar, Long-Term

The US Dollar Index (USDX) measures our currency’s strength relative to a basket of well-known currencies around the world. An increase in the figure signifies dollar strength, and a decrease signifies weakness. In July of 2001, the index was at a multi-year high of over 120. In mid-March of this year, it hit a 35-year low of 70.7. As a general trend, the dollar has weakened since the inception of this index in the early 70s. However, since this mid-March low, the USDX has strengthened 22 percent to 86. The Japanese Yen has also strengthened in close unison with the dollar. But be careful betting that the dollar will continue to gain in value. Recent strength in the dollar and the yen stem primarily from massive “safe haven” buying as investors seek temporary safety from the extreme volatility of thinly exchanged currencies.

A phenomenon called ‘carry trade’ occurs when investors whose home country have low interest rates choose to invest in countries with higher interest rates. In recent years, for example, the Bank of Japan (BoJ) has kept interest rates barely above 0%. Because of this, many Japanese investors have looked at investing in countries with higher bank interest rates like Australia, Korea, South Africa, and New Zealand. Here is a summary of the performance of these currencies relative to the dollar since mid-March:
· Australian Dollar: -41%
· Korean Won: -34%
· South African Rand: -23%
· New Zealand Dollar: -35%

If you have been paying attention to the U.S. Federal Reserve and the BoJ’s recent interest rate moves, you might wonder: Why are so many people demanding dollars and yen as their interest rates move closer and closer to zero? At one point in October, investor’s were actually paying a premium for 3-month Treasury Bills (which translates into a negative return for that 3-month period, excluding exchange rate movements). Shouldn’t investors demand fewer dollars and yen if they are earning less and less interest on U.S. Treasuries?

The crisis of 2008 has brought on a huge flight to safety. What we mean is, as Japanese and American investors expect the worst in a global downturn (like Iceland going bankrupt), they unwind their carry trade positions in foreign countries and repatriate their money. The world obviously views the dollar and yen as two of the safest currencies, which can explain at least part of the strengthening in the USDX.

When demand settles and the smoke clears from our current debacle, investors won’t be satisfied earning a negative real rate of return on their dollars and yen. Therefore, carry trade will re-emerge, and with a US Treasury printing press running on overtime, expect the dollar to continue down its depreciating path.

So what are the factors that will place downward pressures on the dollar for 2009 after all of the safe haven buying recedes? First and importantly, the U.S. will continue to run monthly trade deficits of more than $50 billion. This puts downward pressure on the dollar. Second, the Chinese Central Bank due to pressure from the U.S. will allow their currency to rise in value compared to the dollar. This has the impact of making Chinese goods more expensive in the U.S. which assists U.S. competitors. Third, U.S. interest rates will likely remain lower than those set by the European Central Bank (ECB). The ECB’s mandate is to keep inflation low. They will do this by keeping short term rates well above those set by the U.S. Fed.

So when will the dollar begin to depreciate? As soon as the global angst recedes in the first quarter of 2009.

Aaron Konen and Ernie Goss

No comments: