USD bull momentum continues

Many doubted the USD. Called it dead and buried.

The USD has started to prove a better choice amongst world currencies. Analysts observing the change in the situation have revised estimates of the 2010 value of the USD vs Euro to reflect the trend toward USD strength.

In fact, large amounts of money has also started to point toward continued USD strength.

"According to data compiled by Scotia Capital, traders were net short the euro—meaning on balance they were betting it would decline—by a record $9.9 billion last Tuesday.

That is a 31% increase from the previous record set a week before. Traders were net long U.S. dollars by $7.9 billion, on a par with levels last seen during the financial crisis."

Once again, there are huge deflationary forces taking hold this year....

1. HAMP ends, massive short sales to ensue
2. Agency mortgage purchases by the Fed end (at least for a little while, may restart later)
3. QE using treasury purchases end (again, probably temporary - six months at most)
4. World wide stimulus programs end (South Korea, Brazil, Australia, India, etc)
5. No cash for clunkers
6. Declining influence of the US fiscal stimulus

... and many more

Plus the "flight to the USD" effect from...

1. Euro zone debt crisis
2. Dubai "restructuring" (default at 60 cents on the dollar)
3. Would you put your money in China an export economy with stimulus at 20% of GDP???
4. Massive Japanese QE (Not here yet, but definitely coming by May, no doubt)

Even though the US has huge debt problems, compared to other countries, their issues look reasonable. The Economist ranks the US and UK after the PIIGS for sovereign debt risk.



The flaw the US is the relative short maturity date of the debt. But one crisis at at time. For now, there is no problem rolling over US treasuries in short maturities and thus the USD IMHO is still on a long bull run.

Is it time for the USD to show some muscle?

The US dollar has been kicked, spit on, and left for dead in 2009. Gold bugs, fiscal conservatives, and doomsayers all have abandoned the US currency in anticipation of economic meltdown due to the massive amount of debt spending to slow the crisis.

But have USD critics gotten ahead of themselves?

* Oil has overshot against the USD

Since March, USD has fallen less than 20% vs the Euro, but oil futures have increased 40% in anticipation of a collapse in the purchasing power of the USD. Yet that has not happened...

...and as time ticks by, the disparity between the increasing inventory of oil in the market and the demand on the exchanges becomes more and more peculiar.

* Even weaker currencies have gained 30% vs USD

Emerging market currencies such as the Colombian Peso, Brazilian Real, and Turkish Lira all have gained over 25% vs the USD in a just six months. Although their futures are bright, there are still significant political risk to emerging countries that is now disregarded in the purchase price.

* Lots of deflation on the horizon

The market has been bearish on the USD since March. But considering the wind down of stimulus in the next few months (Treasury purchases, MBS purchases, Cash for Clunkers) and also housing programs (HAMP, Housing Tax Credit), the deflation of reduced economic activity should be significantly bullish for the USD.

* USD is reaching historical support levels

Emerging economies need the USD propped up to maintain exports and keep the flow of hard currency into their country. This historical chart underscores the importance of the US economy to the world.



* Traders have moved to a net long position on the USD

In fact, it has been noted recently that traders have switched to a net bullish dollar position.(1)

* USD reversal could cause market mayhem

Many journalists remark on how the investment banks borrow from the Fed for free and invest in other currencies to obtain a spread. This is called a carry trade and it has helped banks such as Goldman Sachs, Morgan Stanley and JP Morgan book billions during this year. Roubini thinks an uptick in the US dollar will lead to a massive carry trade unwind.

“Everybody’s playing the same game and this game is becoming dangerous.”

The dollar has dropped 12 percent in the past year against a basket of six major currencies as the Federal Reserve, led by Chairman Ben S. Bernanke, cut interest rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. Roubini said the dollar will eventually “bottom out” as the Fed raises borrowing costs and withdraws stimulus measures including purchases of government debt. That may force investors to reverse carry trades and “rush to the exit,” he said.

“The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.”(2)

The author of this blog thinks it is time for the USD to correct, but that it is too risky to play for a major spike in the USD. In the case there were unforeseen banking issues in Europe or in a significant emerging market, a run to the USD could be damaging to US banks who are leveraging USD.

The author recommends buying SCO under $13 and exiting above $15.5

(1) Forbes.com, "Stronger Buck Threatens Stocks And Commodities", Ryan Campbell, Nov 3, 2009

(2) Bloomberg.com, "Roubini Says Carry Trades Fueling ‘Huge’ Asset Bubble", Michael Patterson, Oct 27, 2009

Defensive Investing: Preparing for a currency war

Many people have been talking about how low interest rates and stimulus will devalue the USD. It is more interesting to talk about how long the Fed will apply pressure to the value of the USD and what to do about it.

Historical analysis that says that the Fed usually keeps rates low until 1 year after the peak of unemployment. Since we have not hit the peak of unemployment yet and do not expect it to occur until the beginning of 2010, the Fed will flood us with money until 2011. The USD has already lost 20% of it's value, and could lose another 10-20% more value in the next year.

But the economic policymakers outside the US are not naive. A low USD is like a tariff on imports for America. They know this and like to counteract the problem. On Tuesday Brazil put a 2% tax on all foreign investment into their country to devalue THEIR currency against all other currencies. The next day Turkey announced a similar proposal. Southeast Asian countries (Thailand, Indonesia, Hong Kong, Singapore, Malaysia) have started buying the USD to try to devalue their own currencies against the USD.

So what are we seeing, no one is going to take this lying down. It will turn into a currency war, with everyone racing to the bottom. Southeast Asia and Brazil can put in counter measures, but that only slows the progress. The USD will devalue, but at what price? The US has the biggest pump to flood the world with money, but it does not mean we will benefit the most from the flooding? Likely, but not necessarily.

What to do?: 100% of the known readers of this blog receive income in USD, have debt denominated in USD (if they have debt), and have over 90% of their available cash denominated in USD. A little diversity is a nice defensive measure and never hurt anyone.

As the USD devalues, emerging market currencies become more expensive and stocks in emerging markets equity prices rise. But in this environment owning equities is just like owning a lottery ticket. I think owning emerging market bond fund (EMB) or government debt of other countries (IGOV) in very small portion for a buy and hold scenario is a good step hedging step. Even better is just getting a CD denominated in currency in countries with 1) manageable deficits or no deficit 2) commodity exposure that is an Achilles heal to a devaluing USD (i.e. oil). Two safe choices for the next couple of years will be CDs denominated in the Brazilian Real or the Norwegian krone. Offered at Everbank.com with a minimum $10,000 deposit per CD, the CDs can be rolled every 3 months. The annual interest rate is 4.5% for the Brazilian real and .25% for Norwegian Krone. The money will be there and protected from the degradation of USD and is FDIC insured to boot.

Author recommends opening one rolling 3-month CD denominated in Brazilian Real and 3-month CD denominated in Norwegian Krone.