August 02, 2002 - Morgan Stanley Global Economic Forum
Currencies: An Interruption in the USD Correction Likely in Q3
Stephen L. Jen (London)
Another Mini-bear Market USD Rally Likely in Q3
I believe that the USD is likely to stabilise in the coming months (Q3), even though it is still in a multi-year structural correction. An interruption in the structural USD correction is likely because: (1) the market’s focus is shifting from structural to cyclical issues, and may start to consider that the higher the risk of a second dip, the better the USD is likely to perform; (2) the USD may not be as over-valued from the perspective of the financial markets, even though it is still massively over-valued from the goods-market perspective; (3) the USD is still the economic safe-haven currency, even if it has lost its shine as the geopolitical safe-haven currency.
Always Challenge the Consensus View
I have always been a contrarian and generally believe that consensus views are guilty until proven innocent. The consensus view that is mostly priced into the market is bad for spotting turning points. The consensus view is essentially a view galvanised by momentum, which means that it, by definition, lags the market. Back in late February/early March, when we first argued that what we were witnessing in the market was a multi-year structural peak in the USD, there were few believers. I argued that the important trigger for the USD to suddenly turn south was ironically because the US economy began to bottom much earlier than the market had anticipated, and much earlier than the demand from the rest of the world had bottomed. This meant that the already large external imbalance of the US had to start expanding again. Hence, we believed the USD had to head lower in late February, even though the C/A problem had been a concern for years. But as the USD sell-off gained momentum, market participants began to search for justifications, and finally convinced themselves that the US external financing problem would be the dominant force in driving down the dollar. A prevailing view in the market is that the US$1.2 billion a day of US financing needs will not be filled, which could trigger a crash in the USD. This view is so entrenched that I am concerned that investors are about to miss another turning point in the G3 currencies.
Modestly Bullish on the USD in Q3
By Q4, if our central case assumption of a recovery in the US materialises, the structural correction in the USD that commenced in March should resume. However, I believe that the USD may stay on the strong side in Q3, or at least not sell off as sharply as it did in Q2, and there are three main reasons behind this modestly USD bullish view for Q3:
Reason 1. The market is likely to shift its focus from ‘structural’ to ‘cyclical’ matters. In my view, the reason why in Q2 the G3 currency trades were so simple and straightforward was due to the benign environment of stable equity prices and a recovering US real economy. This economic backdrop allowed the market to focus on the structural USD over-valuation, and nothing else. However, with the meltdown in global equity markets, the risk of Steve Roach’s ‘double-dip’ scenario appears to have risen significantly: the revised GDP data for 2001 and the preliminary read of Q2 GDP support Steve’s view. My personal view is that the probability of such a scenario has doubled from 20% in Q2 to 40% now and that, while it is still not the most likely scenario, the risk has risen sharply. With the possible out-turn of the US economy becoming more ‘binary’, i.e., the probability distribution function for the US economic outlook has become bimodal, I believe the market will continue to be much more focussed on the cyclical arguments, than the structural USD argument. What this means is that the structural USD correction will likely be interrupted in Q3, before resuming in Q4, if my assumption of an eventual economic recovery materialises. The key point here is that the USD can only correct in a benign environment. In my view, a USD crash is not possible in a double-dip, as a double-dip would undermine growth in Europe, Japan, and the emerging markets.
I expect weak equity markets will not only have a negative equity wealth effect on consumers, they will also retard business investment as the cost of capital rises (the ‘Tobin’s-q’ concept of capex). Both typically work to compress domestic demand, and lead to lower GDP growth. If this effect is strong enough, a double-dip could result and the sharply compressed domestic demand should translate into compressed imports and a sharp narrowing in the C/A deficit. If the C/A deficit of the US collapses from 4.5% to 2.5% of GDP, why should the USD crash if the US no longer needs so much foreign financing? The clearest trade in a severe double-dip is to buy USD/Asia, in my view, since Asia is one of the regions most leveraged on global demand. If the Asian currencies collapse in a double-dip, how can the USD crash? Having said this, one of the remarkable observations of yesterday’s US GDP data is that, despite weak demand from the US, Asia’s exports still rose sharply and its external balance significantly improved, which suggests to me that Asia is more under-priced and resilient than I had thought. In any case, while I continue to believe that a recovery is more likely than a second-dip, the fact that the risk of the latter has risen should remove the short-USD/Asia positions in the market and encourage the JPY-bears to come out of hibernation, at least temporarily, in my view. In Q4, further evidence of continued recovery in the US should send these JPY bears back into their caves, but I believe USD/JPY and therefore USD/Asia will trade higher in Q3 than in the latter part of Q2 or Q4.
The story for the EUR is somewhat different. The Euroland economy may not be as leveraged to global demand as Asia is. However, its domestic demand is very weak. Our European economics team just revised down this morning their growth forecasts for 2002 and 2003. I have long argued that EUR/USD rallied by default, not by merit. I believe Euro area’s domestic demand is simply too weak to digest the strength in the EUR. This is the main reason why I believe the EUR is stalled here and will likely end the year below parity. Further, in the event of a double-dip in the US, I believe various structural problems in Europe will surface, constraining the ability of the EUR to rally. A sustained rally in EUR/USD, in my view, is a 2003 story, when the Euroland economy will have gained some momentum to absorb a stronger EUR.
Reason 2. USD-assets already re-priced. We argued previously that an elevation of risk aversion is bad for the currencies of the capital deficit countries. Thus, the reverse should provide alleviation to them. As US stock prices stabilise and stage a bear-market rebound, the USD should be supported. One way to think about the USD is to consider the concept of USD valuation from two distinct perspectives: real and financial. From the ‘real,’ or the goods market perspective, we believe the USD is clearly still over-valued, in light of the yawning C/A deficit. This is essentially the basis of our valuation work done by Fatih Yilmaz. However, at the same time, what is difficult to capture in the traditional valuation framework is the issue of currency valuation from the perspective of the financial asset markets. With the 12-14% correction in the USD against the EUR and the JPY year-to-date, USD assets have had a 12-14% discount from the currency adjustment, on top of the 30-40% correction in USD prices. To the extent that the USD assets were over-valued at the beginning of the year, they are that much less so today. Stabilisation of US equities should allow global investors time to reassess this change in asset valuation.
Reason 3. USD still the economic safe haven currency because the US Treasuries are the ultimate safe haven asset. Even though the USD may have lost its shine as a geopolitical safe haven currency, it is still, in my view, the safe haven currency of choice and US Treasuries the supreme safe haven asset, for economic uncertainty, particularly as an insurance against a double-dip. The overwhelming preference for USTs by Asian investors is familiar. But further credit events in the world, which may still occur without a second-dip, could push capital into USTs. In addition, I believe the current turmoil in Brazil could lead to capital flight from a broad range of emerging markets.
The USD Is Still in a Structural Correction
The USD is still over-valued, in my view. In fact, yesterday’s US GDP data suggest that the USD may be even more over-valued than we had thought, because the US C/A deficit was huge despite weak demand. This structural USD negative likely will persist for an extended period. When the concerns about a double-dip evaporate, which I believe they will, the issue of external financing is likely to come back to haunt the USD. If the rest of the world is given some more time to gain composure to absorb the effects of a weaker USD, I expect further USD weakness in 2003.
Bottom Line
This structural USD correction was never going to be a straight line. I believe that a ‘double-dip scare’ is likely in Q3, and will grab investors’ attention away from the structural USD negatives that drove the USD weaker in Q2. I see a brief period during which the structural USD correction could be temporarily interrupted. (In the unlikely event that the US economy ‘hard lands,’ I believe the USD could stabilise and could even stage a mini rally against both the JPY and the EUR.) By Q4, the fog should lift on the US economic outlook and the USD resume its down-path.
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