'Just found this thread from someone on Zeev Hed's thread on IHub.
I am short the dollar, and have been since August, through March puts, I am short the S&P through March puts and long gold through April calls. I also own a large position in HMY - just bought it on Friday.
To say the least, I am bearish, and have been since early 2000.
Sorry if this old news, but I am not going back to read thread history.
Ken Wilson
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Stephen Jen works for Stephen Roach at Morgan Stanley. He is their international currency expert, and is based in London. I have a lot of respect for him, and have been reading his columns for as long as I have read Stephen Roach - three years. The dollar is helping gold, and will continue to, in my opinion.
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Currencies: Twin Deficits -- USD No Longer the Lord of the Currencies
Morgan Stanley's Global Economic Forum - January 17, 2003
Stephen L. Jen (London)
Twin Deficits Set to Breach 7% of GDP
For the first time since 2Q85, the combined US fiscal and current-account (C/A) deficits look likely to breach 7% of GDP this quarter, and move into the 8% range by 2004. In my view, this ‘twin deficit’ problem will become so severe in the coming two years that I believe it will overwhelm other factors that may be USD-positive. The USD resumed its structural correction on 6 December when Secretary O’Neill resigned, and will continue to depreciate against a broad range of currencies throughout this year, in my view.
Third Phase in This ‘Stuttering’ USD Downtrend
This USD correction is very different from the weak USD periods of 1985-87 and 1994-95. One key difference is that the current structural USD correction has already been interrupted several times, while the previous two USD corrections evolved more in a straight line. The global economic backdrop is substantially more fragile and uncertain now than in the other periods; and extreme economic weakness and uncertainty have proven to be USD-positive and were, in my view, behind the stop-and-go nature of this USD correction (our ‘USD Smile’ concept). In assessing this ‘stuttering’ USD downtrend, therefore, my focus has been less on the simple ‘crash versus no-crash’ debate, and more on identifying the conditions under which the USD can correct, and those under which the USD is supported.
The USD first began its structural correction in July 2001 (see Questioning the Longevity of the Dollar Dynasty, S. Jen & J. Fels, 26 July 2001). This correction was interrupted by the terrorist attacks in September 2001 and the events that followed. I believe that fear-motivated capital supported the overvalued USD between September and March 2002. The USD did not resume its second phase of correction until March 2002, when (1) concerns emerged about the commitment of the Bush Administration to the strong USD policy following the imposition of steel tariffs, (2) the financial markets stabilised and (3) investors began to price out the risk of a double dip. The perception that the global economy was returning to a ‘benign environment’ released risk capital out of the US, and the USD went into a broad-based descent between March and July of 2002 (see The Dollar is Likely to Enter a Gentle Descent, 7 March 2002). The violent meltdown in global equity markets last July rekindled investor fears and, as a result, USD bonds and the USD itself benefited from such extreme risk aversion. This helped the USD remain stable for most of 2H02.
The resignation of Secretary O’Neill on 6 December 2002 marked an important turning point for the USD in my view, for it signalled that the Bush Administration may take the opportunity of the personnel change to (1) further modify its policy on the USD and (2) introduce a large fiscal stimulus. I believe this event triggered the third phase of the USD decline. In a note last week (Fiscal Deficit + a C/A Deficit = a Weak USD, 9 January 2003), I argued that a further move away from former Treasury secretary Robert Rubin’s definition of a strong USD policy would take out the tailwind that has been so powerful in pushing foreign capital into the US in recent years. At the same time, fiscal stimulus in a weak global economy will exacerbate the US’s external deficit. A simultaneous fall in the supply of and a rise in demand for foreign financing will be USD negative.
Why Is the Twin Deficit Bad for the USD?
Twin deficits occur in economies that are both saving-short and whose public and private sectors are out of balance. In the late 1990s, the world was eager to invest in the already saving-short US economy because the US was not so much seen as saving-short as investment-rich. It was thought that the US C/A deficit was justified because investments in the US carried persistently higher returns on capital and that such a saving deficit was a sign of strength, not weakness.
Things are different now. Investment in the US has collapsed, and the world has realised that the US return-on-capital premium was more of a mirage than a miracle. Without Keynesian stimulus, domestic demand in the US would have weakened and the C/A deficit would have naturally declined toward what is considered sustainable in the long run. However, with massive monetary and, now, fiscal stimulus to resist this weakening in domestic demand, the saving deficit is, effectively, not allowed to shrink. The C/A deficit in the US looks set to be kept high not because of high investment, but because of lower net savings (the public sector dis-saves on behalf of the private sector) to match lower investment. This is a critical change in the USD story, one that is missed by those who believe a fiscal stimulus will boost economic growth, which in turn will support the USD.
How Big Is the Twin Deficit Problem?
To come up with a composite measure of the severity of the twin deficit problem, I simply added the size of the fiscal and the C/A deficits (in percent of GDP). 7% seems to be a critical threshold. The last time this level was breached was in 2Q85. That was also when the USD index peaked, followed by a 30% correction over the subsequent 2-year period. (The Plaza Accord, on 22 September 1985, was announced several months after the USD had already begun to correct.) Based on the latest forecasts of our US economists Dick Berner and David Greenlaw, incorporating what we believe will be included in the latest fiscal package, this twin deficit index will reach a historical high of 8% by 2004! While there is nothing ‘magical’ about the threshold of 7%, that this measure of the twin deficit problem looks set to reach the highest level in recent years is important.
Tying This In with Our Valuation Work
My concern about the growing twin deficit problem is also conceptually consistent with our fair valuation work on the USD, which identified four key drivers of the long-run fair value of the USD as (1) relative productivity, (2) terms of trade, (3) the relative fiscal position, and (4) the net foreign asset (NFA) position of the US. The twin deficit problem of the US essentially captures the latter two variables: relative fiscal position and the external financing position of the US. With the emergence of the twin deficits, the USD’s underlying fair value has been drifting lower since the beginning of 2002. The market value of the USD must decline if only to keep pace with the falling fair value.
How Much Further Can EUR/USD Rally?
The USD has weakened by around 6% against the EUR since the beginning of December. How much further can EUR/USD go? It’s tough to say. However, I note the following. First, in my view, the Euroland economic and EUR stories are not compelling. This move is not an EUR story; it’s decidedly a USD story. I believe the EUR has been rallying by default, not by merit. Second, having said this, the EUR is one of the best alternative currencies to hold, particularly for the two key groups of foreign exchange holders in the world: the Asian central banks and the oil-exporting countries (at current oil prices and supply levels, there are, annually, some US$800 billion worth of fresh petrodollar receipts slushing around). Capital exit from the USD could mean a powerful run into the EUR. Third, the key medium-term issue arising from the rally in EUR/USD, from Europe’s perspective, is clearly export competitiveness: How strong a EUR could the likes of Germany absorb in the current environment? The ratio of Euroland’s output elasticity with respect to interest rates and that with respect to the exchange rate is roughly 6:1, i.e., a 5% change in the average annual index value of the EUR has the same effect on GDP as a 75 bp change in interest rates. This means that, to offset the effects of a 10% rise in the value of the EUR this year, the ECB would need to bring the refi rate in line with the current level of the Federal Funds Rate. Since the average value of EUR/USD was 0.95 in 2002, the current spot is already more than 10% higher. Thus, I would be surprised if I don’t hear some verbal intervention from the Europeans to try to cap the rise in EUR/USD. The ascent in EUR/USD will slow or be suspended as a result.
Bottom Line
This is still a decidedly a USD story, not a EUR-, JPY-, AUD-, or a GBP-story. The twin deficit problem in the US is becoming very serious and, in my view, will overwhelm other factors to drive the USD lower this year. The sum of the fiscal and the C/A deficit will, for the first time since 2Q85, breach 7% of GDP this quarter. Coupled with the high likelihood of further modification on the USD policy, the USD should continue to weaken this year to equilibrate the supply and demand of foreign financing for the US.
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