The dollar conundrum

I still remember the time around 8-9 months back in May – June 2008 when we were seeing an unbridled rise in commodity prices and the US dollar was continuously falling in value. The expert opinion at that point of time was that the collapse of the US Dollar was imminent and the Dollar might fall to as low as 2 vis a vis the EURO. That was the time when I was observing the technical charts of USD Vs the EURO and there was a clear double top formation happening and I had opinioned that a sharp rise in the value of the US dollar was imminent. The reasons for that was unclear at that time. However it was clear to me that commodities were in a big bubble cycle and would crash badly and the US Dollar will move up in value.
The event has now happened and despite a virtual “falling off the cliff” of the US economy the US Dollar has continued to march forward. So what are the reasons for this and whats the future directions. I will lay down several reasons for the upward movement of the USD and the readers are free to make their choice of the major reasons.
Reason 1 – The first and foremost reason for the upward move of the USD is flight to safety where investors have been dumping all other kind of risky assets in order to invest in US Government Treasuries and Bonds. This has led to a huge influx of money into these assets from all over the world. The magnitude of this is likely to be over a Trillion dollars since the middle of last year. This has had two affects. The value of the US Dollar Index which is the most followed index tracking the value of the USD vis a vis other currencies has moved up from a low of 70 to nearly 90 which is a gain of nearly 30%. The yields on US government 10 year bonds have fallen to nearer to 4% to around 2.9% in the same time frame. This has lead to a phenomenon where not only investors are making a significant capital gain on their investment in US Government Bonds but also on the currency as the USD has moved up significantly in value. This has become a self fulfilling prophecy like is there during most bubble formations. Risk is getting significantly over priced from being severely underpriced in the period 2006-2007.
Reason 2 – The second reason for the upward movement of the US Dollar has been the lack of confidence in the Japanese economy due to a lack of political will in that country to move on economic revival and also the structural deficiencies in that economy given its demographics. We have also seen Japan go into a Current deficit after more than a decade due to the collapse of its exports which is unlikely to revive anytime soon. As a result there is no real logic for holding the Japanese Yen. The EURO which was supposed to lead the move against the dollar is facing problems of its own due to the diverse nature of various European economies and the fact that the bad apples of the Euro Zone like Spain, Italy, France ( to some extent), Austria ( due to its lending to Emerging Market countries of Eastern Europe) is now no longer a homogenous group and there are various pressures on a common policy response in Euro Zone. This has bought the continuation of the EURO as a common currency into question and in this period of uncertainity no one wants to take a risk. In fact my good frient Mohit Verma believes that the United Kingdom with its collapsing economy, fragile financial system, reckless fiscal discipline and the latest addition of monetizations risks going to the IMF for a bailout sooner than later. The Chinese Yuan which could be a safe haven currency is not an open market as of today.
Reason 3 – The third reason is the instability of Emerging economies that were largely dependant on US consumption for their growth and a large part of their exports going towards US consumption. A large number of these economies had also borrowed substantially in Foreign Currency ( mainly USD ) under the assumption that the USD will keep on depreciating and today we are seeing a Déjà vu of the 1997 Asian currency in Eastern Europe where the currencies of these countries have collapsed and the repayment obligations are such that they are likely to take these currencies to bankruptcy. This is making roll over of Dollar liabilities difficult.
Reason 4 – Fourth is a reason that is more temporary in nature where there is a redemption out of emerging market equities, hedge funds, commodity funds etc. For example Hedge Fund assets have fallen from USD 1.9 trillion to around USD 1.2 trillion in the last 9 months. Since most of these investments were denominated in USD there is a temporary surge in the demand for that currency to meet redemption liabilities thus causing an upward pressure on the USD.
Reason 5 – Fifth, due to the collapse of US consumption demand the US trade deficit is likely to come down substantially as not only overall volume imports come down but the value of imports will also come down substantially due to the collapse in prices of most imported products. This is also reducing pressure on the USD and putting pressure on the currencies of the major trading partners of the United States.
There might be some other reasons also that i would have missed out.
The Indian currency has also been losing value along with other emerging market currencies despite the fact that the trade deficit has started to come down and will continue to fall right through the year 2009. The major reason for this has been persistent FII selling, reduction in FDI flows as well as uncertainity on the roll over of External Commercial Borrowing (ECB’s) falling due in the current year. I belive that the rupees fundamentals are actually improving and after seeing a fall to levels of around 54 in the near term the direction should reverse.
Overall taking into account all the above factors I believe that the USD Index should continue to trend up in the near term and could go to a level of 94-95. However there is no fundamental case for the long term upward movement of the US Dollar given that state of the US economy and sooner than later we are likely to see the start of the fall in the value of the US Dollar specially against currencies of major emerging economies like China, India, Brazil etc. The upward move of the Dollar should peak out by the second quarter of the current year which should also be the bottom for equity markets all over the world.

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