... more macro stuff from Morgan Stanley's Global Economic Forum, November 18, 2002
Currencies: Is This the Beginning of the End for the US Dollar?
Stephen L. Jen (London)
No, it is not. The conditions are not ripe yet
While I have been arguing for close to two years now that the USD is grossly over-valued, I don’t hold the view that we are witnessing the beginning of the end for the USD, at least not yet. Here, I would like to clarify my perspective, including attaching a level of conviction to my call and to the important assumptions underlying it.
My call
I believe the USD will eventually correct, but not before it has rallied one more time in the coming months, particularly against the Asian axes. In my view, the USD is over-valued, and this point is no longer in dispute. The challenge I see, however, is in identifying the conditions under which the USD can be allowed to correct, and in anticipating the "texture" of this dollar correction (i.e., symmetry between the EUR and the JPY and speed) when this structural descent commences. In my view, fixating on the valuation of the USD will lead the investor to miss all of the turning points in the USD. At the same time, what is more important is that the valuation of the USD is only one of many key factors to consider in thinking about the USD. It is by no means the only or the dominant factor. Specifically, I believe the USD — the only currency in the world that commands a "hegemonic" status — will be supported in periods of extreme greed or extreme fear, regardless of valuation. This means that the key question to answer is whether risk aversion is heading higher or lower in the months ahead. At this moment, I attach a higher probability to "things getting worse before they get better." This is why I have a more constructive short-term view on the USD. In my view, however, a prospective USD rally merely postpones the inevitable structural correction in the USD. When US yields bottom in earnest, that is when I expect the USD will resume its structural descent. In short, I believe we are likely to remain in a "trading" environment in the months to come, while 2003, however, is likely to be a "trending" environment.
To elaborate my view, I make the following clarifications:
Point 1. The all-important assumption is that global investor risk aversion rises again. For the USD to rally, I believe risk aversion, which has declined recently with the recovery in the equity markets, must elevate again. Only risk-motivated capital flowing into US bonds can push the USD higher, in my view. This scenario is predicated on global equities sagging again, overwhelmed by the weak global economic activities. I should underscore that I feel less confident about this assumption than about my framework linking the USD with the economy. If I am wrong in making the assumption that the US economy double-dips, then what we are witnessing could indeed be the beginning of a structural correction, I concede. Notwithstanding this possibility, I continue to believe that there are few reasons to expect a recovery in capex. Corporate de-leveraging and balance-sheet cleanup may have indeed been taking place. However, this does not mean that the money saved will be spent. Japanese corporates have relatively healthy cash positions precisely because they have stopped investing and dis-saving like they did in the 1980s. The irony here is that if the US corporates "do the right thing" in shrinking their balance sheets, I believe the US economy will likely double-dip. I will refrain from going into this double-dip debate again here. But the key point I want to make is that if the global economy falters, it will be hard for the USD to correct, even though it is over-valued.
Point 2. Asian investors play a critical role in the USD story. I believe the role of the Asian investors in propping up the USD is under-appreciated by the market. Asian central banks own some US$1.4 trillion worth of foreign reserves. In addition, the private sector commands an even larger stock of liquid foreign assets. Their strong preference for USD assets is the key reason why the USD was supported between 11 September 2001 and March of this year, and why the USD correction was arrested in September, in my view. Focussing on the demand for financing in the US (C/A deficit) tells only half of the story on the USD. It is also important to know under what conditions will the suppliers of this financing stop sending money to the US. Asian investors will continue to send money to the US as long as they themselves have no use for the surplus capital, in my view. For investment demand to recover in Asia, the global economy must stabilise first. The is a key thought in my "Dollar Smile" framework (see S Jen & F Yilmaz, November 29, 2001), which makes the counter-intuitive argument that the USD can only correct if the "worst is behind us." Another channel through which Asian investors can play a critical role is in how geopolitical safe haven capital can flow into USD assets if there is military conflict in the Middle East. Whether European or Japanese investors hide in USDs if a war breaks out is less important, in my view, than whether the AXJ (Asia ex-Japan) investors move into USD assets. I continue to believe that, in times of elevated geopolitical tensions, the dominant preference in AXJ remains USD. Even though investors in developed economies and oil exporting countries may not have as high a USD preference as before, Asian capital will likely remain USD-friendly and will be strong enough to support the USD in the event of unrest. Third, this role played by the Asian investors has grown sharply over time, along with their export prowess. This is why in the current situation, the "Dollar Smile" is likely to be even more "curved" now than the historical data imply.
Point 3. Watch the US yield curve. If I am right with my view that equities will be dragged lower by the weak global economy and that global risk aversion will rise again, the yield curve in the US should fall again. As long as the yield curve declines, capital will flow into the US. I think the market is overly fixated on the cash rates between countries. Cross border capital flows are not only driven by relative levels of yield but also the expected capital gains. In my opinion, even though the Federal Fund Rate is already very low, there is still ample scope for the long bonds to rally if the US economy slows. I am looking for the long bond yield to bottom. When that happens, it will be an indication that the world has already priced in the bottom in the US economy. When the market is sure that the "worst is indeed over", the USD should resume its structural correction in earnest.
Caveats to my view
In addition to the uncertainty regarding the outlook of the US economy, there are other considerations that may marginally affect my "Dollar Smile" framework.
First, there is the possibility that investors are "getting used" to the highly uncertain environment. Specifically, I wonder if investors’ risk aversion is a non-mechanical function of the volatility in the market or in the economy, such that, over time, risk aversion gradually declines even if uncertainty remains unchanged. To the extent that investors have built up an "immunity" to uncertainty, the magnitude of the risk-motivated capital flows into US bonds may be marginally tempered, i.e., it may take a more violent second dip in the US economy to generate the same rally in the USD than during the period between 11 September 2001 and March 2002.
Second, the Republican victory in the Senate and the House suggests that the US may be the only G3 economy that will be able to inject both fiscal and monetary stimulus, while Japan and Euroland will remain partly constrained on the policy front. What this means is that the US C/A deficit likely will be larger than otherwise, and that the eventual correction in the USD likely will be greater.
Third, the market seems to now be rewarding "policy credibility" rather than "pro-growth" policies. In light of the Fed’s and the ECB’s decisions last week, I believe it is clear that the US is going for "growth" while Europe is going for "stability". However, at these low levels of interest rates, "pro-growth" monetary policies may no longer be credible and the market may have doubts about whether further easing will have traction in the economy. When a central bank enters the "pushing-on-a-string" zone, policy credibility could suffer. I believe the recent softness in the USD may reflect this change in market sentiment.
Bottom line
Recent developments in the currency markets suggest that the worst is behind us. If the market is right on this view, then the USD should continue to weaken. Such a development would be very consistent with our "Dollar Smile" framework. However, I hold a more pessimistic outlook on the global economy, and am looking for risk aversion to rise again. If this scenario materialises, I believe the USD will be able to reassert itself again, particularly against the Asian axes. But this rally likely will be short-lived. When US yields bottom, fear-motivated capital inflows into the US will dwindle, undermining support for the USD. That will likely be the true beginning of the end for the USD.
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