Phillip Coggan of the FT Joins the Cautionary Chorus
who are calling for a severe bout of dollar strength. (Note how the article gets mushy and unclear though towards the end--not only in a sign of "journalism" but perhaps as an indication the main ideas has little follow through...)
The Long View: Expect the unexpected
By Philip Coggan
Published: March 12 2004 14:59 | Last Updated: March 12 2004 14:59
Expect the unexpected. If there is a consensus in the financial market, it is that the dollar is headed down. And indeed the dollar "ought" to fall. The US has a huge current account deficit, which a dollar decline will help correct.
But when everyone in the market is positioned one way, there tend to be some nasty surprises. The dollar has come within touching distance of $1.30 to the euro on a couple of occasions but each time has been forced back up. It was at $1.22 on Thursday.
Some analysts now worry that the financial system is vulnerable to a sharp upward move in the dollar, which could undermine the speculative positions taken by banks and hedge funds in the market.
It all boils down to the informal deal that exists between the US and Asia. The US buys the exports of the Asian countries. To ensure that their exports remain competitive, the Asian central banks intervene in the foreign exchange markets. By doing so, they sell their own currencies and buy dollar securities, thereby financing the US budget deficit. In effect, Asia exchanges its goods for US pieces of paper.
It seems a good deal to both sides. Flourishing exports are helping to revive the Japanese economy and provide jobs for China's workforce as it transfers from the agricultural sector. By keeping US bond yields low, Asian intervention prevents the US from paying the price of its profligacy and allows the Bush administration to stimulate the economy ahead of the November presidential election.
The loser from all of this has been Europe. With the dollar fixed against the renminbi and allowed only to trickle lower against the yen, the euro has largely taken the strain, and the effect is starting to show. The US had a record trade deficit of £43.1bn in January, but within that figure the deficit with the eurozone narrowed from $11.1bn to $6.6bn. Europe's trade position is deteriorating.
What would happen if the US/Asia deal broke down, even temporarily? It is rare for currencies to move in a straight line and, now that the trend has changed, it must be tempting for the dollar bears to take profits, pushing the dollar up against all freely floating global currencies.
European politicians and central bankers might breathe a sigh of relief. More crucially, however, the Chinese and the Japanese would at best have no need to intervene and, at worst in the former case, might need to sell dollars to prevent their currency falling from its peg. Neither central bank would have any need to own Treasury bonds.
Who then would support the US budget deficit? To some extent, private overseas investors might fill the gap. After all, a rising US dollar would make Treasury bonds more attractive.
But there is a risk that the demand from such sources will be insufficient, given the current level of yields. Christopher Watling of Longview Economics (no relation, but a trademark lawsuit is in the post) argues that the risk involved in owning Treasury bonds has risen to a record.
He cites three reasons for saying this. First, the US Federal Reserve has changed its monetary approach and is not tightening rates as early as it would have done in previous cycles. Such changes of regime are usually associated with greater risks (particularly of inflation) for bond investors. Second, he refers to the high overseas ownership of Treasury bonds. Third, he argues that the high current account deficit is a sign of the US economy's vulnerability.
Watling adds that bond yields could easily reach 6 per cent in the current cycle. He says that between one and three percentage points is the historical range for real bond yields and that inflation could easily reach 3 per cent as the economy expands. That would involve heavy losses for investors, given that 10-year bond yields are now below 4 per cent.
The bond markets could be very vulnerable to a change in sentiment. According to Jes Black, currency analyst at MG Group, speculative long bets in the five-year Treasury note rose to a record of 250,000 contracts in the last week of February.
In effect, investors are borrowing short at ultra-low interest rates, and lending long. This "carry trade" can be immensely profitable for a while, but leaves investors potentially vulnerable.
Traditionally, that vulnerability has occurred when short rates have started to rise. That was what occurred in 1994 when the Federal Reserve tightened monetary policy dramatically, causing the worst bond market for decades. The Fed had kept rates low in the early 1990s to allow banks to recover from the bad debt problems associated with the recession. Investors had become used to the carry trade but were forced to reverse positions quickly as short rates rose; one or two hedge funds went bust in the process.
This time round, however, it seems unlikely that the Fed will raise rates for a while; any pressure would have to come from higher bond yields. But such speculative sell-offs can occur, as we saw last summer. Once yields start to rise, many investors have to sell to cover their positions, particularly in the mortgage-backed market.
Surveys suggest that investment banks, lulled by the recent low levels of volatility, have substantially increased the capital they are committing to trading. A sudden shift in the market could cause many of them to cut their trading positions at the same time, exacerbating any price move.
A sudden lurch higher in US bond yields would also have significant economic effects. US consumers have enjoyed an income boost from lower bond yields, which have enabled them to refinance their mortgages. The corporate sector will also have benefited from lower borrowing costs. Higher yields would cramp their finances, causing them to cut their expenditure. Economic growth would start to falter.
"Anecdotal evidence," says Jes Black, "suggests that speculators in the US bond market know they are leveraged to a falling dollar and foreign demand for US debt. If this trend were to reverse, speculators should watch out for a rising dollar, rising yields and falling stock in the months to come." |
