... Stephen Roach hits the nail on the head again ... not that I have the stature and background to pass judgment on him, but he presents a strong case that the dollar will NOT collapse ...
... right now, the US Dollar Index is at 111.95 ... and it looks to me that as long as it does not take-out 110.00 that now might be the time for the dollar to rally (as it is set-up to do), while gold corrects (as it is set up to do) and the Nasdaq 100 rallies (as it is set up to do) ...
... note however, the dollar, gold and the Nasdaq 100 are NOT set-up for short-term entry ... I am not budging yet ... I got long the dollar on April 29 (when it was set-up long term, but not short term), and got creamed ...
... not that I think the bear market is nearly over, but this market looks close to a rally ... we will see ...
Ken Wilson
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... from Morgan Stanley today ...
May 31, 2002, Global: What If the Dollar Crashes? by Stephen Roach
Our central case continues to call for a soft landing of an overvalued US dollar. According to Stephen Li Jen, the dollar began this year about 14% overvalued. Against that backdrop, our baseline global forecast incorporates two years of 7% declines in the trade-weighted value of the dollar in both 2002 and 2003. By our reckoning, such an orderly currency depreciation would leave the dollar "fairly valued" by the end of 2003. Such a soft landing would be just what the doctor ordered -- it would go along way in facilitating the rebalancing that a US-centric global economy so desperately needs.
Everyone knows that a soft landing of the dollar is in the world’s best interest. Stephen Li Jen has also done a masterful job in making and defending this case (see his 22 May dispatch, "The Case for a Soft Landing in the USD"). Yet, however compelling the logic, history cautions against betting too heavily on soft landings in overvalued asset markets. Once they finally give way, market excesses have a painful knack of getting corrected rather quickly. Remember Nasdaq 5000? The Nikkei at 38,900? The dollar collapse of the mid-1980s? In all of these instances, the adjustments were swift and wrenching -- with landings that ultimately had little respect for the equilibrium valuations of our finely calibrated models. While the trade-weighted dollar is down only about 3% so far this year, it has now fallen about 9% against both the euro and the yen. With the downslide accelerating in recent days, fears of a hard landing are now in the air. As always, it’s the tails of the probability distribution that tend to have the greatest impact on financial markets.
Largely for those reasons, we feel it’s appropriate to ponder the low-probability ramifications of a hard landing for the dollar. By Stephen Li Jen’s reckoning, a dollar landing would qualify as "hard" when the greenback’s monthly declines against other major currencies exceed 3% (see his dispatch, "Defining a USD Hard Landing"). In keeping with this metric, we have examined a hard-landing shock framed around a 20% drop of the dollar against both the euro and the yen by the end of 2002. Relative to levels prevailing on 24 May when we first began to ponder such a scenario, this shock would be sufficient to take the dollar/euro cross-rate to 1.15 and the yen/dollar to 100. What would be the implications of such an outcome?
In theory, shifts in relative prices -- and that’s exactly what a currency is -- should have a zero-sum impact on the global economy. In the simplified construct of a two-country world, a shift in the currency alignment would find one economy gaining and the other losing. In the case of a soft landing for the dollar, I believe the zero-sum global outcome would be reasonably close to the mark. A strengthening of both the euro and the yen would restrain export growth in Euroland and Japan, while stimulating foreign demand for US-made products. Inflation would be a little higher in the United States, but a bit lower in Euroland and Japan. By impeding external demand, a stronger euro and yen would put some additional pressure on both Europe and Japan to implement additional reform and restructuring initiatives; a failure to do so would result in a permanent erosion of market share in an ever-expanding global economy. I would be willing to bet that Japan, in particular, but also Euroland will take extraordinary actions to ward off just such a possibility.
Elsewhere in the world, the open economies of Asia would be most affected by a depreciation of the dollar. Inasmuch as half of non-Japan Asia -- China, Hong Kong, and Malaysia -- is pegged to the US dollar, a depreciation of the US currency would provide a significant boost to these nations’ exports. Korea, which accounts for another 25% of pan-regional GDP, has a currency that moves in much closer alignment with the yen; for that reason alone, a crash in the dollar against the yen would boost the won and severely crimp Korean export growth. Taiwan is also yen-sensitive, but as Andy Xie notes, its currency only moves by half as much as the yen; as a result, any export hit on Taiwan would be relatively muted when compared with the rest of the region. Andy estimates that the first-round effects of a dollar crash would boost pan-regional exports to Japan and Europe, sufficient to raise Asian real GDP growth by approximately one percentage point in the year immediately following the depreciation.
A hard landing, I fear, would be a different matter altogether. Export compression would be more immediate in both Japan and Europe -- probably sufficient to knock around 0.5% off real GDP growth in the first year and even more in the second. The resulting pressure on exporters would undoubtedly trigger intensified corporate cost-cutting of both capacity and headcount, resulting in second-round effects that would restrain capital spending and personal consumption. In the United States, the currency-induced boost to exports would be an obvious plus -- sufficient to probably boost real GDP growth by a little less than 0.5% in the first year following the dollar’s crash. The inflationary consequences would be comparable -- an immediate 20% depreciation of the dollar likely would boost US inflation by about 0.4% over the next year.
But there’s more to the story of hard landing for the dollar than the macro of price and income effects. In my view, a dollar crash would have a devastating impact on US financial markets. Foreign investors would continue to reduce their exposure to dollar-denominated assets, and US investors would undoubtedly rebalance their portfolios in an effort to seek greater exposure to non-dollar-denominated assets. The result would be lower prices for equities and bonds alike. This could have significant negative consequences for a wealth-dependent US economy. It would undoubtedly deal a blow to consumer confidence, finally sealing the fate of the long-awaited consolidation of the American consumer. The negative asset effects would also result in a higher cost of capital that would most likely impede business capital spending. In short, under a hard landing, wealth effects driven by further downward pressure on asset prices could swamp the positive benefits of the income and price effects. That would spell tough news for the US economy -- more than enough to stoke renewed fears of a double-dip. Nor would the rest of the world -- still overly dependent on the US, in my view -- take kindly to wealth-induced shortfall in America. If the world’s growth engine gets hit by a currency-related wealth shock, the global reverberations would likely come at a fast and furious pace.
Yes, a hard landing of the dollar is a low-probability event. But so, too, is the creation and subsequent popping of any asset bubble. In many respects, the strong dollar was the linchpin of the virtuous circle of the late 1990s. Yet in the post-bubble era, complete with an ever-widening US current-account deficit, the strong dollar has remained largely unscathed -- at least until recently. But suddenly the bloom is off the rose. Fears of a profitless recovery raise serious questions about returns on dollar-denominated assets. America’s recent protectionist forays -- especially steel tariffs and increased agricultural subsidies -- hardly instill confidence in the dollar as the mainstay of global commerce. Nor does the Bush administration get high marks in the international community for its recent handling of geopolitical crises. There is a general perception that US foreign policy has become increasingly ineffective by spreading itself too thin on three fronts -- the war against terrorism, the Middle East, and India-Pakistan. Suddenly, all that looked virtuous about America looks increasingly vicious. For an overvalued currency, that spells trouble -- not just at home but elsewhere around the world. If the dollar crashes, the global economy could be in serious trouble. Let’s hope it won’t.
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