Stephen Jen of Morgan Stanley London comments that their models indicate the USD is undervalued about 25% relative to the Euro. Read the whole thing for interesting observations on Bernanke’s verbal forex intervention, Secretary Paulson’s visit to the Middle East, and the feedback cycle of the weak USD on oil prices:
5. Other considerations favour the dollar, even in the absence of the recent US rhetoric. Before this round of verbal intervention, we already had the view that the USD should eventually reassert itself. Regular readers should know our basic argument. But just as an update, the US C/A deficit continues to shrink and could reach 4.5% of GDP by year-end, down from 6.7% in 4Q05. At the same time, the USD is very undervalued. EUR/USD’s median fair value, according to our valuation framework, is 1.24.
Impact on Oil and Other Commodity Prices
The direct impact of the latest round of verbal interventions on the USD may be well-recognised. However, I believe that the more important implication is that a determined USD rally could cap the rise in crude oil. As we have argued in the past, the dollar’s weakness has helped to propel oil prices higher, through both the numeraire effect and speculative activities. In turn, high dollar prices of oil conveyed the impression that inflation is higher than it was, and much of the rest of the world has reacted with a more hawkish monetary stance. The resulting yield differential further depressed the dollar, setting off another round of this vicious circle. I believe that the dollar has grossly undershot, and suspect that oil has overshot. If the bottom in the USD indeed coincided with the top in oil and other commodity prices, then all the commodity-exporting currencies should suffer. In earlier notes (see DEFCON-3 on Some Emerging Market Currencies, May 15, 2008 and Four Fall-Lines of Dominos: An Ordinal Ranking, May 1, 2008), we ranked currencies according to the net trade position in commodities. On this measure, CLP, NOK, AUD, NZD, ZAR, TRY and ARS look vulnerable. Clearly, a stabilisation or a correction in general commodity prices would have much broader implications beyond the currency markets.
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