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Whither Dollar?

Who would have thought that the world would be carrying trading against the dollar?

Over the recent weeks the trend of the falling dollar and rising gold prices  has been too stark to ignore, with the currency at a historic low and the commodity at a high.

A look at the gold chart tells you that the rally is not finished that, in fact, it could well be entering its ‘irrational phase’. That is to say, the current worldwide ‘consensus of dollar depreciation’ can create a situation where everyone enters into one-way trades, selling the US dollar and buying something else — currencies, commodities, and assets.

The fundamental reason for this state of affairs is that there is a huge increase in the supply of dollars (due to the easy money policy of the US Federal Reserve (US Fed)). A low Fed rate of 0.25 per cent is a clear communication that the US will hold low rates for at least 6 months. In short, this is a guarantee from the Fed that one side of the carry trade is predictable (i.e. you can borrow dollars at <0.5% for the period).

Now, the question that this gives rise to is: Where is the money going?

The Australian dollar (AUD) has seen an rate hike by 0.25 per cent, a clearly AUD positive move, which will drive incremental flows into the currency. The natural flows from any US dollar selling will go into the Euro — long-term average of 63 per cent, so any US dollar depreciation should be reflected 63 per cent into the Euro. But, that is not the case just now and that, is very significant.

It means the flows out of the dollar are veering round to other (minor) currencies like the AUD, Indian rupee, etc. We can see that the rupee has moved dramatically in the recent past, breaking the Rs 48 bottom very sharply, while the Euro has yet to break its earlier top of 1.48.

In other words, the dollar has turned into the money supplier of the world, a position hitherto reserved for the Japanese yen (JPY). We already know that Japanese savings have collapsed, and this is expected to be a long-term trend. Its population is expected to tip over into a post-retirement ‘dis-savings’ age, when they start to draw on their savings. This is expected to push Japanese government debt to 240 per cent of gross domestic product (GDP) by 2014 — above the bankruptcy line. In short, we can ignore the JPY as a source of the carry trade in future.

How do you think this is happening? US stimulus money (Troubled Asset Recovery Programme) funds are fed into Citibank, which starts to ‘lend’ out to safe businesses. Since nobody has any appetite for risk-taking, these ‘businesses’ park the money in a European bank, denominated in Euro deposits, say, with RBS. So, now, they have sold the dollar and bought the Euro, and are getting a good yield on their Euro deposits, besides the 15 per cent currency appreciation in Euro.

RBS has no business any more, and doesn’t want to lend anyway. So, believe it or not, it is buying Citibank CDs, simply because reserve requirements on TARP-fed banks is now lower in many European countries. All this counts as ‘business’ in both countries and the money returns to Citibank, to start its circular journey all over again. Just imagine what will happen when the Fed decides to hike interest rates and this ‘carry trade’ unwinds.

In the old Japan-funded carry trade, the money used to go back to savings-surplus Japanese investors, who just had to park it somewhere. So, you had this build-up of carry-trading, followed by small bubble collapses, temporary runs on various borrowing currencies like AUD, NZD, SAR, CAD, etc. But the money would return, and the party would reflate all over again. This time, however, whenever the US government pulls the plug on the TARP funds and ‘books profit’, the funds will have to be returned for good. And maybe the second wave of the Great Depression of 2008 will start.

On the one hand, the US Fed has offered its own ‘moral hazard’ to bond traders, by promising to keep the rate unchanged at current levels. Even the great Paul Krugman has put his weight behind this policy, saying clearly that with inflation well under control (because it has been exported through the carry trade), there is no way the US should bring down rates till unemployment starts to fall from its currently horrendous 9.8 per cent level — he recommends holding down rates for 2 years. Just the mere act of saying this will create expectations that will push the Dollar Index (DXY) down below its historic low levels of 76 just now. And that is a self-fulfilling prophecy.

Krugman argues that this is good for the US exporters and points to the falling current account deficit, now down to about $250 billion. All very good for the US, but do consider how the imbalance is building up on the other side.

I had argued in an earlier article that US demand for world’s savings was falling off a cliff and old imbalances were correcting spectacularly. Structurally, if the US turns into a clean energy supplier, it would bring back huge value to the dollar, completely upsetting the current consensus.

The fundamentals may or may not change, but technically, who would have thought that the world would be carrying trading against the dollar? US’ stimulus-based liquidity is now supplying speculative positions in emerging markets and high-yielding currencies, with talk about gold doubling from these levels. If all this happens, we could see the DXY index at below 60. Few realise it, but the dollar is in territory similar to where the stock market was in Oct-Nov, 2008; and we know what happened to those sellers.

I don’t know the bottom for the dollar, and I could be wrong by very large margins, but I do know this for sure. If you look at the gold-dollar chart, the area between the 2 curves is already at a 30-year high, beating the 1985 spike to $850 during the Iran crisis. Either you now believe that: a) The dollar will never come back, but there is nothing that suggests this — I would rather say that for Europe, than for the US; b) Something is wrong somewhere. I am still a cautious gold bull, but the relative movements with the Euro/JPY would suggest that the dollar looks the strongest of the 3 big currencies on current fundamentals. So, sell JPY, buy gold, might be the trade of the decade!

The column was published in the November issue of Wealth Insight magazine. To subscribe, click here.

Also See: Gold