Fundamental FX Triad

As we recall, the US dollar reached relative highs in March after its 24% rise from the 2008 lows. While the recent sell-off has been across the board, losses against commodity currencies have been pilling-up. The Australian and New Zealand dollars are each up more than 20%, and the Canadian dollar has gained 16%. There have been two distinct waves to the dollar’s recent weakness. Initially, the dollar sell-off was driven by investors looking for signs of global economic recovery. As confidence increased, investors rushed into buying risky assets, and abandoned safe-haven U.S. government bonds and the dollar. Then, toward the end of May, investors became worried about the potential for a downgrade of the U.S. sovereign-debt rating and sold-off the dollar again. Let’s address few fundamental aspects within the FX space.
The level of US government debt as a percentage of GDP has increased from a recent decade low of 48% in 2001 to 56% in 2007, and 2009 forecasts read a level between 60% and 90%. However, government-debt levels are increasing in all countries as they attempt to stimulate their deteriorating economies. US debt ratios are still low, relative to many countries, even based on 2009 projections. Furthermore, Fed’s quantitative easing might turn positive for the dollar in the long-run. As of May 31 2009, the Fed had purchased only $130.5 billion of the authorized $300 billion in long-term Treasury debt, and $481 billion of the authorized $1.25 trillion of mortgage-backed securities. In the midst of the dollar sell-off on fiscal concerns, credit agencies Fitch and Moody’s claimed that “it is premature for the US rating to be in play” and that the credit rating is stable “even with a significant deterioration” in the nation’s debt burden.
Interest rates have not been the primary driver of currencies for a couple of quarters. After all, central bank policies have converged at very low levels, and longer-term yield differentials have narrowed as well. Even if central banks remain on hold for an extended period of time, I expect longer-run rate differentials to start diverging. The path of Europe-US differential depends to a large extent on the Fed. The ECB is almost guaranteed to remain on hold as Europe faces deflation and weakness in lending growth. As US growth outpaces Europe’s, US interest rates will pick-up faster than those in Europe.
Back in 2007, the investors were worried about a massively growing US trade deficit, and they were selling dollars because of it. The US trade deficit has been improving over the last three years. As long as this trend continues, there is one less reason to sell the dollar. On a similar note, the traditionally low US savings rate has improved to almost 6%, a 14-year high in May. It appears that America’s external borrowing requirements declined 50% year-over-year as monthly deficits dropped to $30 billion per month from more than $60 billion.
Recently, the dollar strengthens when the economy declines and loses value when economic growth quickens. Relative GDP growth rates, trade deficits and interest rate differentials have receded for now as determinants of global currency movements, and have been replaced by the overall prospects for global economic growth. At the moment, it looks like the global activity indicators suggest that the worst is behind us and that the economy should do better going forward. One of the few breaks for the U.S. consumer came from falling oil prices in the final quarter of 2008 and the first quarter of this year. Every $1-dollar-per-gallon price increase reduces the annual spending power of US consumers by $140 billion. The biggest effects are not seen until three or four quarters after the price change, which means that we are still benefiting from last year’s price drop. However, with oil prices rising more than 100% from the lows in December 2008, and US gas prices up more than a dollar per gallon, it is obvious that the continued rise in oil prices will weigh on the US consumer spending power.
The best thing you can say about the euro currency is that it is not the US dollar. That means that whenever risk appetite increases, investors leave the safety of U.S. government bonds and EUR benefits by default as the alternative reserve currency. It is the only other currency that has the liquidity and reputation to serve as a means of settlement, store of value and unit of account. Nonetheless, it is well known that Western European banks have significant exposure to many troubled Eastern European economies and that fact contributes to the overall uncertainty about the viability of the Euro-zone. On one side, euro currency presents some positive aspects: (a) the only alternative to the dollar; (b) a strong momentum; (c) sustained risk appetite and (d) higher commodity prices add to diversification demand for euro. On the other side it has some major disadvantages: (a) market expectations of Fed hikes within 12 months and a USD curve-steepening; (b) ECB intent on slow and measured monetary response; (c) banking sector over-leveraged and overexposed to emerging markets; (d) recession in Europe deeper than in the U.S.; (e) inability of the Euro-zone to respond with one fiscal policy; (f) overvalued based on purchasing power parity.
The unusually sick Japanese economy found no better ground this quarter, although industrial production has been stronger than expected. With risk appetite on the rise, the Japanese yen (JPY) has been a laggard, as factors supporting its rise last year – the collapse of global interest rates and the rapidly slowing U.S. economy – are no longer at play. While the risk aversion sentiment favors the yen, any excessive strength would be met by the threat of intervention by the Bank of Japan. We should all agree that Japan needs its biggest trading partners, China and the US, to recover. On one side, JPY presents some positive aspects: (a) the currency benefits during periods of risk aversion; (b) tax breaks for Japanese corporations to repatriate overseas profits; (c) expectation of trade surplus improving as U.S. and Chinese economies recover. On the other side it has few disadvantages: (a) domestic economy in a prolonged recession; (b) vulnerable to renewed weakness in U.S. and China; (c) worst gross debt/GDP ratio of any major economy; (d) threat of intervention if yen strengthens below 85 per USD; (e) G7 statement warning against excessive yen volatility.
Bottom line, in the short term, dollar weakness may continue, but in the longer term several factors are working quietly to the dollar’s advantage: an improving trade deficit and savings rate, expected interest rate differentials and higher GDP growth potential. Remembering that I once used to trade FX for living, I am going to make a 12-month forecast call for a stronger dollar (EUR:USD at 1.25 and USD:JPY at 105).