Seeker Blog

Marc Chandler, chief global currency strategist at Brown Brothers Harriman, will receive this week’s Best Chart prize [PDF] . Click on the graphic at left to enlarge.

Recall that we are looking at two variables, the dollar’s value and the direction of short-term interest rate differentials. With two variables there are four possibilities: There are times when there is a weak dollar while interest rate differentials move against the US, which has been the case in recent quarters. The dollar may remain weak as interest rate differentials begin moving in its favor. The dollar could strengthen as interest rate differentials continue to move in its favor and later the dollar could strengthen when interest rate differentials begin moving against the US.

Since the late 1970s, the dollar appears to be moving consistently and sequentially through the four different phases. We are not pretending to offer some kind of Holy Grail. The limitations of this conceptualization are stark. It says nothing about the duration; how long the dollar spends in any one phase. It also says nothing about magnitude; how much the dollar appreciates or depreciates in any phase.

Nevertheless, the dollar’s location in its super-cycle helps identify the underlying trend and may be more useful for long-term traders than short-term speculators. In particular, recent developments lead us to believe that the dollar may be moving from what we have labeled Phase 4, where short-term interest rate differentials are moving against the US and the dollar is falling to Phase 1, where short-term differentials begin moving in the US favor, but the dollar remains soft against the euro.

…The economist’s equivalent of Occam’s Razor, the philosophical principle that the simple solution is preferable is that cyclical explanations ought to be given precedence over structural explanations and only when the former prove unsatisfactory should the latter be relied upon. We have maintained that the dollar’s decline was largely a cyclical phenomenon, largely a function of growth differentials mediated by interest rate differentials and divergence in monetary policy between the Federal Reserve on one hand and the ECB on the other.

The structural reasons other observers cite, like diversification of reserves or the loss of the dollar’s status as the numeraire in the world economy we find lacking much evidence. The most authoritative data, which comes from the IMF shows central banks hold more US dollars than ever before. The US does of course still run a large trade deficit, even if it has fallen in recent quarters. Nevertheless we have found that over half the trade deficit can be accounted for by the movement of goods within the same companies. These intra-firm movements of goods, as trade has been in effect in-sourced, often do not require countervailing capital flows but are rather book entries in corporate accounts. In addition, while the US is the world’s largest exporter, its companies rely on local affiliate sales rather than exports as the chief method of servicing foreign demand. Sales by the majority owned affiliates of US multinational companies will sell something on the magnitude of four-times the amount the US will export this year.

The US dollar bottomed against half of the non-US G7 currencies, sterling and the Canadian dollar, last November. The dollar’s location in its super-cycle does not preclude a marginal new low against the euro. It does support our view, however, that the dollar’s multi-year downtrend is nearing an end. The shifting of interest rate differentials, which investors should continue to monitor, is another piece of the jigsaw puzzle falling into place for a broadening of the dollar’s base in the period ahead.

For an illuminating interview with Chandler I recommend Tom Keene’s May 28 podcast at Bloomberg on the Economy [MP3], offering lots of statistics comparing US and EU performance. And how the Euro has not helped EU productivity. How US productivity growth over the past 3 decades has continued to outpace the EU countries.

BTW, Chandler is not a member of the “US Dollar is finished” club — e.g., see this April 4th analysis [PDF]

Much foreign exchange commentary these days reads like eulogies for the US dollar. Central banks are diversifying reserves away from the dollar. OPEC countries are increasingly worried about the decline of the dollar and the inflationary implications and may break the pegs and possibly even begin benchmarking their black gold in euros rather than dollars. The aggressive US policy easing and the financial crisis, which none less than former Federal Reserve Chairman Alan Greenspan has said is the worst since the Great Depression, contributes to the lack of attractiveness of US assets. The low rates of return in the US will make it increasingly difficult to fund its large current account deficit, which in turn will continue to undermine the dollar. This pessimism is exaggerated and ignores evidence to the contrary. Moreover, the very fact that sentiment is so poor and short dollar positions so extensive may be more symptomatic of a market extreme than the beginning of a trend.

One of the weights on the US dollar has been the belief that foreign central banks have a clear alternative to the debt-ridden greenback as a reserve asset. Yet the evidence for this is sketchy at best and depends on when one wants to begin counting from. The IMF recently reported the allocation of reserves for Q4 07, which of note excludes China as China does not provide a break down of its reserves. The share of allocated reserves accounted for by the dollar actually rose slightly to 63.9% vs 63.8%. Given the dollar’s depreciation in the quarter, the fact that its share actually rose suggests, contrary to conventional wisdom, that reserve managers are reluctant to sell dollars at these levels.

That is clearly the message coming from foreign officials. On March 12, speaking at an ECB conference, the head of the Saudi Arabian Monetary Authority, Hamad Saud al Sayari, explicitly stated that the dollar was a “good buy”, as the rout looks overdone and the dollar under-valued. Less than two weeks later the head of Kuwait’s Investment Authority, thought to be one of the largest sovereign wealth funds, indicated that he was going to boost investments in the US because the weaker dollar made US assets more attractive.

…We would recast the debate over if and when the US dollar will bottom. We argue that it is already bottoming. Not including the dollar, there are four other currencies in the G7 and the dollar appears to have bottomed against two of them, the British pound and the Canadian dollar. If it has not bottomed against the other two, the euro and Japanese yen, we suspect it has come close to what will likely be the cyclical low. The Australian and New Zealand dollars may find it difficult to rise through the Q1 highs set near $0.9500 and $0.8215 respectively. We also believe the US dollar has bottomed against several of the major emerging market currencies as well, like the South African rand and Turkish lira.

…Instead of intervention, our more positive dollar argument is based on its relative cheapness, the changing behavior of investors and businesses, and the fact that the bad news from the US is widely known while the magnitude of the challenges faced elsewhere do not appear to be generally appreciated. The dollar has already bottomed against half of the G7 currencies and several key emerging markets. We expect that bottom to broaden out in the period ahead.

I do hope Chandler is right that the AUD run is over.