Strength in US dollar in short term

Future gazing: strength in US dollar in the short term:

In my previous post, I discussed the fundamental underpinnings which would lead to a weakening dollar in the medium term. This is expected to happen though when stability returns to the markets - be they financial, foreign exchange or commodities. Moreover for the dollar to start weakening, clarity on the fate of Euro zone economies is critical. As it stands today, in the short run, US dollar is perceived to be the currency of choice. Interestingly, the dollar is strengthening at a time when it is clear that the fundamentals of the US economy are deteriorating. The very pillars of financial strength and leadership in the areas of politics, high end financial services, manufacturing and R&D which gave the US dollar its underlying strength and resilience are shaky and no longer the sole hegemony of USA. The collapse of the unfettered laissez- faire Capitalistic system has Europeans and Chinese gloating over their version of Capitalism adulterated with Socialism in various degrees. The European Union under the leadership of a rejuvenated France is offering a non confrontational yet nuanced counter vision to the American world view. On the Industrial front, the Chinese are increasingly moving up the ladder of R&D driven manufacturing processes while the Japanese, Taiwanese and the Koreans continue to chip away the American dominance in high tech in their areas of expertise.

Then what is driving the US dollars strength in the short term. It is a combination of the following:

• A transparent & self cleansing US Capitalistic system: The faith in the US system’s inherent ability to cleanse itself at a faster pace than others is reassuring to the investors. It is a process driven to a large extent by transparency of the Financial Institutions now that they are under a scanner. The pace at which the US government has reacted to the crisis and the bipartisan manner in which both the Republicans and the Democrats have rallied around the Treasury’s efforts to find a solution has also worked to soothe investor nerves to an extent. It is reassuring to know that the entire might of the US government is at work trying to ease the crisis though the overwhelming view at this point in time coalesces around a prolonged economic slowdown. . I have been speaking to a whole range of financial players and the investors appear to be more scared of the dangers emanating from opaque holdings of various European banks than the relatively known problems of the Americans. It is no secret that European banks were significant investors in rated bundles of US mortgage securities, smug in the belief that the high yields were seemingly secure by the investment grade stamps provided by the various rating agencies. Now that the ratings have been rendered impotent and the value of the illiquid securities is plummeting with no buyers around, these banks will have to take huge write offs. Barclays, RBS and Lloyds have each sought $26bn to strengthen their balance sheets while almost all European governments have sought to guarantee investors deposits to shore up the faith in the banking system. A flight from Euro in such a scenario works in favour of the Dollar.

• Worsening European Economies: The fast deterioration in the European economies is unnerving investors globally. Sustained interest rate cuts in the Euro zone are on cards in face of the worsening economies thereby dimming the returns on the Euro. The Central banks across the North Atlantic are flooding the system with liquidity, as spooked lenders refuse to lend sparking a severe credit crunch all across. Short term commercial paper is finding no takers shutting off the spigots on a critical short term financing instrument.Britain is facing its own version of the mortgage crisis with the collapse of banks there and the fall in the real estate prices which has started gathering a momentum and pace of its own. Job losses in the financial sector are not confined to New York alone. London which had attracted droves of Investment banking activities and was positioning itself as the new financial center of the world will take some serious amounts of time to recover from the job losses there. Further, the hectic pace of events on the Wall Street and the massive US treasury response has left London reacting to events as a marginal bit player. Consensus seems to emerging on the impending acceleration in slowdown in Germany and France. The failure of Hypo Bank and Fortis and the bailouts in Iceland has unnerved further the already frayed nerves in Europe.

• Unwinding of short dollar trade: According to the foreign exchange traders I spoke to, there are still huge short positions in US dollar. The short dollar trade was a huge success for a long time though the reversal in dollar’s movement did catch a lot of investors by surprise. However, the prevalent belief is that there are still substantial short dollar positions that need to be unwound.

• The collapse of the decoupling theory & few safe currencies: The myth of the so called decoupling of the Western and Eastern economies has been conclusively broken. The belief that somehow the rest of the world will be insulated by the troubles in USA has proven to be more of a hope than substance. The slowdown in the US has already started to impact Singapore where the government is warning of several stressful quarters that lie ahead. China has seen a collapse in the stock markets as well as real estate and a significant slowdown is on the cards there. Hong Kong is impacted by default. The implied slowdown in demand for commodities subsequent to a slowing global economy is reflected in falling commodity prices and as a consequence commodity plays like Australian Dollar have seen a significant fall. Semi Oil and commodity plays like Canadian dollar and Russia have also suffered though the reasons for fall in the rouble are many (Georgian invasion and deleveraging leading to a stock market selloff being significant contributors besides falling oil and commodity prices). India too has been impacted due to expected slowdown in earnings from software exports and FIIs taking over $25bn out of the country over the first six months of the current financial year. The fall in oil has not been able to compensate for deteriorating government finances in India. Japanese exporters too would be impacted by a slowdown in the US and China. The Japanese auto manufacturers have a huge presence in America while Japan was a significant beneficiary of the ongoing demand for Capital goods from China. The troubles and travails of currencies across the world has diminished the problems of the dollar in comparison and a short term flight to safety seems to be on the cards. That said the Yen probably might be better placed than others to withstand this financial tsunami affecting markets, economies and currencies across the world.

The Japanese have been adept at fighting a stagnant economy for over a decade now and their banks have rebuilt their reserves and war chests. Mitsubishi picking up a 20% stake in Morgan Stanley and Nomura buying the Asian and Indian operations of Lehman is a sign of Japanese strength. Another holdout might be Brazil where there have been huge oil finds and the macroeconomic indicators are holding up well with inflation in check and steady GDP growth estimates. Traditional safe heavens like Switzerland too will be seeing inflows in the short run.

The near unison in which almost all asset classes have moved down has been a significant feature of this crisis. Diversification across asset classes has not helped. The unexpected strength in the US dollar has caught many folks on the wrong foot. The swiftness of the crisis marked by forced deleveraging in face of incessant margin calls has seen many diminishing fortunes and a realignment of the pecking order of the global rich is on cards. Whether the US enters into a severe recession and a prolonged economic downturn will eventually determine the fate of the US dollar in the medium to long run. However, in the short term, the travails of rest of the world are helping shore up the US dollar.

Atim Kabra October 7th, 2008