The U.S. Dollar Sucker Rally
In recent weeks, but most dramatically yesterday, the U.S. dollar has rallied. It now stands at its highest level in 6 months and has wiped out nearly all of its losses for the year.
The very dramatic (2% movements in one day is very unusual) surge in the dollar yesterday was most likely the result of purely technical factors. Many fund managers have "stop-loss" rules which automatically compel them to sell any holdings which decline, and once the dollar had risen above a certain levels, funds began to dump long positions on other currencies. And as similar rules apply to holdings of commodity futures, funds have been dumping long positions in oil and other commodities. At the same time, many momentum traders are building up short positions.
The factor supposedly behind the decline that unleashed these technical factors were comments from ECB chief Jean-Claude Trichet noting that growth will probably be weak in the third quarter. Huh? Wasn't that apparent to everyone? And hasn't it been apparent to anyone that rates will be on hold for a while? And how could that possibly explain the dollar rally against virtually all other currencies (A shift in ECB policy should lead to a generally falling euro, not a generally rising dollar) ? This seems to me more like financial journalist-spin rather than the real story, which is about a purely technical dollar rally.
The bottom line is however that the fundamentals remain dollar bearish. The negative interest rate differential will not narrow any time soon even as America remains heavily dependent on foreign financing. This is not just in relationship to the euro, but also against virtually all other currencies, except to a small extent the Australian and New Zealand dollars (which will probably cut rates, but not by much and they will remain very high). The strong momentum of this technical rally means that it could continue for a short while, but as fundamentals ultimately decide medium- to long-term trends, the dollar will soon fall back to its previous lows.
Finally, it should be noted that the person most happy about this sucker rally is presumably Jim Rogers. After having waited in vain since November last year for a sucker rally in the dollar that would enable him to dump all his remaining U.S. dollar assets, the rally has finally arrived (although it should be noted, the dollar is actually still lower than when he started to wait). I hope and think he will take this chance to get out of his remaing dollar assets.
The very dramatic (2% movements in one day is very unusual) surge in the dollar yesterday was most likely the result of purely technical factors. Many fund managers have "stop-loss" rules which automatically compel them to sell any holdings which decline, and once the dollar had risen above a certain levels, funds began to dump long positions on other currencies. And as similar rules apply to holdings of commodity futures, funds have been dumping long positions in oil and other commodities. At the same time, many momentum traders are building up short positions.
The factor supposedly behind the decline that unleashed these technical factors were comments from ECB chief Jean-Claude Trichet noting that growth will probably be weak in the third quarter. Huh? Wasn't that apparent to everyone? And hasn't it been apparent to anyone that rates will be on hold for a while? And how could that possibly explain the dollar rally against virtually all other currencies (A shift in ECB policy should lead to a generally falling euro, not a generally rising dollar) ? This seems to me more like financial journalist-spin rather than the real story, which is about a purely technical dollar rally.
The bottom line is however that the fundamentals remain dollar bearish. The negative interest rate differential will not narrow any time soon even as America remains heavily dependent on foreign financing. This is not just in relationship to the euro, but also against virtually all other currencies, except to a small extent the Australian and New Zealand dollars (which will probably cut rates, but not by much and they will remain very high). The strong momentum of this technical rally means that it could continue for a short while, but as fundamentals ultimately decide medium- to long-term trends, the dollar will soon fall back to its previous lows.
Finally, it should be noted that the person most happy about this sucker rally is presumably Jim Rogers. After having waited in vain since November last year for a sucker rally in the dollar that would enable him to dump all his remaining U.S. dollar assets, the rally has finally arrived (although it should be noted, the dollar is actually still lower than when he started to wait). I hope and think he will take this chance to get out of his remaing dollar assets.
posted by stefankarlsson at 11:42 AM
16 Comments:
Right now the central banks of the world have been massively intervening to support the dollar. This cannot go on forever.
On the other hand the Swedish Krona and the Euro are also sick currencies with runaway credit expansion.
Inflation in Sweden and the Euro area are also high though this fact to some extent is covered up by the weakness of the US dollar which lowers the price of imports and making inflation seem lower than it really is.
So why cant one sick currency - the US dollar - gain against other sick currencies?
Flavian: read the post again where I explain it. Exchange rate movements are ultimately determined by how attractive return are for investors in interaction with current account balances and the U.S. offers one of the worst combinations in the world with low interest rates combined with large deficits.
Which currencies would you recommend as safe havens?
I would not recommend anyone to hold US dollars either, but neither would I recommend euros or sweidish kronas.
But I do believe that the currencies of the following countries are more likely to gain than others.
Malaysia
Thailand
Sri Lanka
Pakistan
Taiwan
Uruguay
Japan
Singapore
Chile
Peru
Australia
However, it might be the case that some of the countries maintain pegged exchange rates and or restrictions on capital movements. In those case I would avoid the currencies in question.
So if I were Jim Rogers I would rather swap my dollars for yen than for euros.
The importance of the current account is almost negligible.
how long do you expect this so called "sucker rally" to last?
With China worried about yuan appreciation impacting exports, and both ECB and BOE abandoning their constitutional commitment to fight inflation through interest rates, this looks like a perfect stage for competitive devaluation. What - or which currency - will give?
I hope you are right. Like Jim Rogers, I am concerned that the dollar is in for a prolonged period of weakness.
However, to play devil's advocate, there are a number of reasons why this may not play out as expected.
First, there is political risk. The conflict in Georgia highlights just how vulnerable the European economy is to geopolitical events.
Second, the present rally could be anticipatory of expected good news, such as withdrawal from Iraq (which would lower the governmental deficit) and a constructive energy policy (which would lower the CA deficit). If the good news is realized, then the gains might hold. If not, this could be a sucker rally supreme.
Third, part of the negativity toward the dollar is the sense that the inflation statistics are being cooked. The Bush Administration has managed to damage trust in government very severely. But if it turns out that the statistics are correct, then American inflation may be less serious than Asian, and to a lesser extent, European inflation. This is because American workers have no ability to force wage rises-- which is probably bad for domestic growth prospects, but good for export growth and inflation prospects.
That leads to a final point: sound statistics for Asia ex-Japan are often hard to come by and sometimes manipulated by governments. Surprises could come on both sides. Bloomberg is reporting that money managers are pulling the plug on the yuan because of Chinese government intervention, so Jim Rogers might actually be having a very bad day.
Currency movements are complex phenomena. Inclusion of political factors in sensitivity analysis is, in my opinion, important. I am at this point completely in the dark as to whether my currency expectations will be winners or losers.
--Charles of MercuryRising
www.phoenixwoman.wordpress.com
Flavian, of course the current account balance matters. A stronger current account balance means that there is greater demand for a currency in order to buy its goods and services.
And as for which currencies are best, that depends on what you mean. The currencies which have the strongest chance of rising in the long run is the Japanese yen and Swiss franc because they have the lowest inflation.
But because interest rates are so low there, investing there makes little sense. The Australian and New Zealand dollars remain best in that respect.
As for the length of this sucker rally, that is uncertain at this point, but probably at least a few weeks but not more than a few months.
Charles, the conflict in Georgia is unlikely to affect the European economies more than the American. Georgia isn't exactly a significant trading partner for either and would be basically completely irrelevant hadn't it been for the oil pipelines. But the hypothetical disruption of these would affect all oil importers equally as oil is fungible.
And I'm not sure there is any widespread awareness of the fact that American inflation statistics are cooked, in the sense that the Americans use a methodology which to a much higher extent than elsewhere use hedonic adjustments and so on to lower the inflation rate.
Yes, the current account matters. But inflation diffrences de facto matter far more.
If you study the Big Mac Index over the years you can see that Swiss inflation is higher than most people believe.
Japan, though, manages to keep the domestic purchasing power of the yen very stable and to some extent even rising. A "Japanese" Big Mac now costs 280 yens and in 1986 the price was 370 yens.
I do not think that interest rate differentials matter too much in a system of floating exchange rates, since the opportunity to gain arbitrage on the basis of interest rate differentials is conditioned by a limited exchange rate risk.
Under the classical gold standard, interest rate differentials made gold flows change directions because the exchange rate risk was limited by the cost of sending physical gold, but today just about anything can happen with regard to exchange rate movements. The same is as with regard to fixed exchange rates is true with regard to the relation between danish krona and euro, because of the ERM-arrangements.
Under floating exchange rates interest rate differentials reflect capitalized future exchange rate movements.
Swiss interest rates are low, because most people, rightly or not, believe that the Swiss Franc will remain stable or rising against other currencies.
Icelandic interest rates are high because most people, rightly or not, have doubts with regard to the future exchange rate of the icelandic krona.
The best book concerning exchange rates in a system of fixed exchange rates is George Goschens book The Theory of the Foreign Exchanges, also available in a Swedish translation: Läran om utländska växelkurser.
In my opinion conventional wisdom concerning exchange rates is based on assumptions with no or little importance in a system of floating exchange rates.
Flavian: first of all, I don't think Big Macs are relevant here as it is only one out of millions of goods and services (there is no reason to single it out any more than fanta, whoppers, red bull or toyota camrys) and moreover it is a nontradable good.
Secondly, the only reason why inflation matters is *because* it affects the current account (trade) balance. Remember, exchange rates are determined by supply and demand for a currency, with supply consisting of domestic demand for foreign goods and assets and demand consisting of foreign demand for domestic goods and assets. If price differences do not cause people to buy where something is cheapest and sell it where it is expensive, which is to say do not cause changes in the trade balance, then it will not affect supply and demand for a currency. and therefore not affect the exchange rate.
Yes, one of the reasons Big Macs reflect domestic inflation rates more precisely than "a broad CPI" is the fact that you cant transport them from one place to the other.
As I understand the theory of purchasing power parity it meens that the price of so called non-tradable products ought to be approximatly the same all over the world, given that there is a sound international monetary system in place.
The enormous differences with regard to domestic price levels we see in todays world, is largely the result of the absence of of a healthy international monetary system.
Flavian, your understanding of the classical purchasing power parity theory is correct in the sense that it concludes that prices for similar goods should be equal everywhere. However, I reject the theory's accuracy and relevance.
It fails miserably empirically because it assumes two false assumptions. First of all, it completely neglects asset markets and the supply and demand for currencies created by them. And secondly, it assumes that all goods can be traded, while in reality that is not true to a lesser or greater extent because of government trade barriers and "natural" trade barriers such as geographic distance and the transportation cost this creates.
My argument is rather that the theory of a uniform global price level is preconditioned by a global and sound monetary system.
If all countries were on gold, all countries would, according to my belief, have approximatly the same price level even for non-tradable goods.
The Netherlands and Germany had a bilaterally and credibly fixed exchange rate and free capital movements and the price of one Big Mac was almost identical in those two countries.
Lithuania and Estonia both have euro-based currency boards and almost identical Big Mac prices.
If all countries were on gold, we would see the same result. The price of non-tradables would converge, although more slowly than the prices of tradables.
Under the precondition of an international gold standard, I fully agree with you that the current account would be one of the most important factors in explaining why some countries would have slightly higher or lower price levels than other countries.
A deficit in the current account would, ceteris paribus, tend to lower the price level in comparison with countries with surplus in the current account.
I would say like this.
Imagine that two countries are under a uniform international monetary system.
Country A has a significantly lower price level than country B. This will tend to create an inflationary boom in country A and a deflationary purgation in country B.
The reason is that nominal interest rates are identical due to free capital flows and that credit demand is higher in the country with a low real exchange rate.
The price of money is determined by supply and demand in the whole area, but "ought" to be higher in the country with a lower real exchange rate with the result that interest rates in the low cost country are below equilibrium with an inflationary boom as the result and vice versa.
This process will operate as long as the price levels are not identical with the result that they will tend to converege.
I do not know tooo much about it, but I am 99% sure that Ecuador and El Salvador has almost identical price levels.
None of them has the right to print dollars, but both use dollars as legal tender.
They are like two countries on gold but without any gold mines. Therefore their respective price levels have to converge and I believe they are identical or almost identical.
However the pressure towards convergence is probably lower under a soft currency system than under a hard - gold - currency system.
Hello Stefan,
I notice in the current sucker's rally of the USD that it has appreciated to a much greater extent against the GBP as compared with other currencies.
Would like to read your views on why you think that is please.
Thank you.
Celal, the explanation is that the U.K. economy faces greater problem than most other economies, which means that traders are betting on more interest rate cuts, even though the recent surge in inflation have postponed them.
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