Monday, January 07, 2008

Will a US recession strengthen the dollar?

Macro Man is in a bad mood this morning. Having enjoyed a relatively hot hand for most of the second half of last year, he's started 2008 ice-cold. Every trade he's done so far this year has been a loser- long silver, the US/Euro swap spread, and the FX beta plus carry basket. The latter was exited early this morning....and now it is coming back hard. The upshot is that Macro Man frittered away a strong start to the month and is now in the hole. While ideas are percolating in his head, his cold hand dictates a degree of caution in throwing risk at the market.

The performance of the dollar since 8.31 EST on Friday has certainly been interesting. The buck had every reason to get caned, and while it certainly gapped that way it's subsequently come back to retrace all of its post-payroll losses and more against the G3. What's going on here?

One possible explanation is an emerging school of thought that a US recession/quasi-recession is actually good for the dollar. According to the proponents of this theory, weak/negative US growth is both damaging to the rest of the world and a catalyst to encourage US investors to bring money back home. The upshot is that there is less demand for foreign assets/currencies and more demand for US assets/currency; hence, the dollar rallies.

Morgan Stanley is among the adherants of this view, with Stephen Jen using a framework known as the "dollar smile." According to this construct, in the event of very weak US growth the dollar goes up for reasons cited above. In the event of very strong US growth, the dollar goes up because of the attractive return on US financial assets. Only in the middle, trend-ish growth scenario does the dollar fall, as investors have sufficient appetite to take risk but US returns are unappealing compared to the rest of the world.

It seems remarkable to consider that a country with external deficits the size of the US could see its currency rally in two of the three "states" described above. Of course, the trend-ish growth scenario can well comprise the lion's share of the time spent in aggregate. Nevertheless, it is probably worth checking to see if the notion that a US recession is bullish dollars holds water.

Macro Man constructed a simple study wherein he looked at the 4 quarter moving average of the normalized deviation of quarterly GDP growth from its ten year trend. He then compared this reading with the subsequent one year change in the Fed's broad USD TWI. The results, while not conclusive, nevertheless represent something of a victory for what one might call common sense. Over the last 25 years, the correlation between GDP growth and the subsequent change in the dollar is 0.4. In other words, when the US economy slows, the dollar tends to fall afterwards. Call it the "dollar sneer."
Of course, the degree of lag appears to vary, which is probably down to the speediness of the monetary response of the Federal Reserve, among other things. Taken at face value, the strong US growth from mid-2007 would suggest that the near-term outlook for the dollar is actually fairly neutral. Yet a GDP forecast profile that's probably reasonably close to consensus suggests that we should expect pressure on the dollar to resume. The fact that real Fed funds rates are already zero offers a powerful disincentive to hold dollars; by the end of the month, real Fed funds will likely be negative.

None of this is to say that a period of US growth of 1% or lower means that the dollar will fall against all things. Weak growth, particularly if it spreads, should have an impact. Macro Man's rule of thumb is that when the poo hits the fan, the money comes home. This is the "left side" of the dollar smile described above.

And who, pray tell, has been the primary recipient of "hot money" capital inflows over the past year or two? Emerging markets and Europe. It's not terribly difficult to construct a scenario wherein weak US growth broadens, and the currency game finally abandons growth (or more to the point, its first cousin, carry) and focuses on value. If so, then the dollar is not the obvious trade, given that it is undervalued against some currencies and overvalued against others. Surely the real trade is to sell those currencies that are overvalued against everything (EUR and GBP) and buy those that are undervalued (BWII currencies and yen)?

Last week, Macro Man highlighted the break of key suport in GBP/JPY. That break has held, though if the MPC doesn't cut rates on Thursday there may be another squeeze on the cards. Another egregiously mispriced pair, and one where there is a political will to see it move closer towards fair value, is EUR/RMB. It remains above its uptrend line since the end of 2005, but that support isn't massively far away. A move to the middle of its range since the euro's inception (hardly something that is out of the question from a fundamental perspective) would yield a move of 15.65%, less carry.Macro Man is somewhat positioned for a "value matters" regime in currencies, via his EUR/USD powerball strip and the short USD/JPY cash position. There is ample scope to add. However, given his cold start to the year and the potential for a further squeeze this week, he'll wait for more attractive levels before layering fresh risk.


Macro Trading Ideas said...

Hi MM, are you thinking to leave your FX carry plus because you don't believe anymore to your model or what?
Sometimes strong dollar in a bearish economic outlook makes sense, in particular versus euro and GBP, and you can take a tactical trade on this view, but way to change your base model?
According to you what can be the trigger for a end of carry trade for more than a week?

Andrea said...

How about your old idea of shorting GBP or do you think it's too late by now? Why not selling a call on GBP/USD or a put on EUR/GBP?

Macro Man said...

Fabio, over the fullness of time carry is in vogue much more often than value, so it is a bit dangerous to ad hoc flip the model off and on. Far better to opportunistically take the other side in the alpha portfolio when the time seems right. In real life, I do use a more sophisticated regime switching model, but that's not something I am prepared to disclose in a public forum.

Andrea, I am waiting for what I presume is an inevitable squeeze in sterling before unched decision on Thursday should provide the opportunity.

Bruce said...

Hi MM, just curious. How do you measure "value" in the currencies world. Is it a value measured by PPP?

Macro Man said...

Bruce, you can use PPPs, but they're not necessarily, that useful for EM currencies. Current accounts are another methodology, though they are impacted by structural/demographic issues on occasion. When I reference value, I suppose I am alluding to a nebulous combination of PPP, current account, and "common sense."

2and20 said...

I think the Aussie Dollar doesn't look to bad at the moment versus the pound. It's been in a pretty tight range for a few years now, and I think as the tide shifts against sterling it could really start to crack.

UK rates at 4.75% and going down
Aussie rates at 6.75% and going UP.

Not that I really believe in commodities sustaining current levels in the medium-term (since a commodity "crack" is what will break Australia), but I think the bad news for the UK is here, and is a while away yet for the Aussie's.

"Cassandra" said...


Yes because:

- de-leveraging will go hand-in-hand with recession

- recession means lower industrial commodity prices (energy included), and so diminshing trade deficit, further benefiting from better agric terms of trade

- foreign rates will fade at a faster pace than US rates (for a period)

- because a large amount of anti-dollar flows are mimetic (multiples of the secular home-bias diminishment) and USD reversal resulting from above will reinforce reversal;

- because there's "value" in what USD buys - relatively speaking. Not just the Florida waterfront, OR/WA Gentleman Farm, but in goods as I just bot Nikon coolpix 5100 in USA for spouse $299 incl shipping. Its GBP300 discounted + shipping in rip-off-land.

Macro Man said...

C, as I said in the post, the money comes home- de-leveraging. While the dollar would benefit in that regard versus Europe and "sexy" EM, the most obvious beneficiary in my mind would be....the yen. Mrs. Watanabe is hardly going to be pinging around in NZDJPY if it's dropping like a stone now, is she?

Similarly, somewhere like China has a) seen a lot of inflow, but a lot of that has been long-term FDI b) could ironically benefit from US recession in some ways, if it encourages firms to be even MORE ruthless in lowering production costs. One would presume that both China will seize export market share from higher-cost production locales in value-added goods when cost containment becomes a paramount issue.

While I'd concur that industrial commodity prices will decline, they'll get nowehere close to their lows in the late 90's/early noughties. Neverthless, it is safe to assume that those currencies that have most benfited from the commodity boom will suffer.

It still looks to me like short Europe v Japan and China is a better currency trade than the dollar.

Macro Man said...

2&20, the problem with the AUD is that the market still believes in rate hikes. What if they don't happen?

Anonymous said...

AUD economy is one of the most correlated ones with the American one. You can kiss your AUD rate hikes goodbye right now (one more max, if that). And speaking of bubbles, under 0.85 in AUD and 90 in AUDJPY, the mkt will take some carry monkeys out back with a big stick and show them why it ain't wise to be buying carry when the world economy may be teetering on the edge of recession... Take a look where NZDJPY and AUDJPY were trading back in 2006 and you might get an idea of what's in store, once the mkt decides to really punish the Mrs. Watanabes and the structured exotic desks of some pretty "creative" banks who call certain aggressive exotic products in AUDJPY and NZDJPY er.. *hedges* for "regulatory" purposes, when the more apt name for them should probably be "hara-kiri trades"... i^i

2and20 said...

fair enough on aussie then. its more that i'm negative on the pound.

i just don't really see the attraction of the Yen...0.5% interest rates and doesn't look like they'll be going up, a slowing economy that's been mired in deflation for ~17 years, high levels of government debt, equities (Nikkei) at just 35% of where they were in 1990, and one of the worst performing stock markets in the world last year...

...doesn't sound like a long to me.

OldVet said...

Just took a small position in Yen on theory that BOJ can't cut rates, and if China speeds up CNY appreciation, Yen will get tag-along benefit as key competitor. Still like CHF and note inflation readings in Zurich are rising slightly.

Paper by BCA/Canada recently posits Fed igniting new bubble to replace older housing bubble, with commodity and EM beneficiaries after some delay. Status loves its quo?