Wednesday, August 20, 2008

Buck Up

Macro Man has finally breached the critical "feeling 80% of his best" threshold and is at long last back in the office for the first time since the first day of the month. Much has obviously changed since he last sat at his desk, not least the look of this very site. Feedback on the new template is welcomed; in addition to a slightly more polished look, it also includes a couple of new features such as the ability to search previous posts, which may prove useful.

In terms of markets, the most obvious change over the past three weeks has been the stunning rally in the US dollar. While Macro Man has previously noted that his anticipated three themes for August were in some ways correct, he will readily concede that he did not foresee the dollar's reversal of fortune.

Now that it's occurred, of course, the two obvious questions are 1) Why has it happened, and 2) What happens next? Macro Man intends to sketch out his initial thoughts below.

WHY HAS THE DOLLAR RALLIED?

While an exclusive focus on post-hoc explanation can be misplaced, Macro Man is a firm believer in the concept that you have to understand what you have seen before you can forecast what you're going to see. In that vein, Macro Man understands the dollar's rally as a confluence of five different factors:

a) Re-coupling. Over the past few months, Macro Man has been operating under an extremely useful analytical framework when it comes to analyzing currency markets. Put most simply, the market rewards those countries where the authorities are focused on fighting inflation, and punishes those currencies where the authorities are more focused on growth. Exhibit A in this regard is of course the US dollar, where Macro Man turned structurally and aggressively bearish nearly a year ago immediately after the Fed started cutting interest rates.

So what's changed, then? A couple of things. Of the popular major-currency alternatives to the dollar, some, such as New Zealand, have already begun to cut rates. Others, such as the UK, have strongly hinted that the prior easing cycle may start up once again. The RBA in Australia has surprised markets by also strongly hinting at imminent rate cuts. And while the ECB has not offered much hope for near-term rate cuts, by the same token they've at least toned down the rhetoric on the prospect for further hikes.

Moreover, the economic cycle in Europe is clearly weakening, and it seems clear that nominal GDP growth in Europe will soon dip below the policy rate for the first time in more than a decade. While the ECB can talk as tough as it likes, it seems increasingly obvious that at some point they will have to capitulate.
This de-rating of the alternatives to the dollar has, it seems to Macro Man, played no small part in bolstering the dollar's fortunes.

b) Commodity feedback loop. For a number of months now, Macro Man has held the unorthodox view that ECB tightening was exacerbating global inflationary pressures by applying pressure on the dollar, thus boosting commodity prices via the invoice currency effect.

Whether this view is correct or not is to some extent irrelevant; what does seem clear is that commodity prices and the dollar had become entangled into the same trade. Thus, when oil started to move lower thanks to lower global demand, an inventory boost, technical selling, etc., this provided a boost to the dollar. Oil traders, seeing the dollar rally, then dumped more oil (and gold traders dumped gold), encouraging a further dollar rally.

Structural commodity longs have, according to the market intelligence that Macro Man has received, bought USD in the currency market as a hedge. What there can be no dispute of, however, is that currency people have pointed at commodities as a reason to buy dollars, and commodity people have pointed at the dollar as a reason to sell oil/gold, etc. Certainly Macro Man has witnessed an amusing repartee on Bloomberg chat between FX and commodity salespeople from the same bank, with each pointing at price action in the other's market as a rationale for movement in their own bailiwick.
As the vicious commodity/dollar cycle turned virtuous, the dollar benefited.

c) Hedging by long-term structural shorts. For the past few years, US investors in foreign markets have had the ultimate free lunch. Not only has topline nominal GDP growth in the rest of the world exceeded that of the US (thereby implying higher local currency asset market returns), but the dollar has weakened substantially as well. Whichever way you looked, these investments have been winners.

However, with growth in the rest of the world slowing and formerly bulletproof markets showing signs of mortality (Bovespa, anyone?), two things have happened. Assets in dedicated non-US funds have started to cash in. This is very imperfectly proxied in the graph below, which charts shares outstanding in the MSCI Emerging Markets ETF available to US investors (Macro Man held it in his personal account until late last year.)
As you can see, there were quite substantial redemptions during the period of equity market weakness from May-July. Although inflows recovered along with stock prices, they never matched previous highs, and recently they have turned south again.

Perhaps more importantly, however, long-term US holders of foreign assets, particularly assets in the rest of the developed world, have realized that they now have an opportunity to lock in extremely attractive exchange rates. While this will not mitigate against declines in the local currency values of foreign assets, it at least provides protection against being shot with both barrels (e.g., a fall in the local currency value of an asset AND a decline in the value of the local currency against the base currency.)

Shortly before he went on his holidays, Macro Man had begun to hear rumblings of "long term real money selling euros that they've held for five years." Subsequently he has heard from a number of counterparties that this flow continued and indeed accelerated during his absence. This type of flow provided support for the dollar at overvalued levels in 2001 and early 2002; with the dollar now undervalued against many currencies, small wonder that it is helping spur a recovery.

d) CTAs awaken. Benjamin Franklin famously said that nothing is certain but death and taxes. Allow Macro Man to add a third item to that list. If a financial asset, particularly a currency, moves far enough, fast enough, trend following models will kick in and exacerbate the trend. The chart below shows the EUR/USD exchange rate with Bollinger bands, which are basically standard deviation intervals around a moving average.

Of particular interest here is the middle section of the chart, which shows the band width. Observe how it spent a number of months at a relatively low level. In this sort of environment, many trend following models switch off, as a narrow band width suggests mean-reverting rather than trending markets. However, the sharp rise in the band width over the last few weeks will have re-ignited these models, who would then have sold EUR/USD with gusto, thus helping the dollar to strengthen.
Indeed, Macro Man has had this experience with his own trend following model, which doesn't use Bollinger bands at all.

e) Addition by subtraction: FX reserve managers find something better to do. Longtime readers will know of Macro Man's firm belief that reserve accumulation shenanigans by a number of emerging market countries (China, India, Russia, the Middle East) has exerted a substantial upward influence on the EUR/USD exchange rate.

Recently, however, the piss-taking activities of many of these countries has waned and even reversed as they have reaped the inflationary harvest sown by their serial local currency selling. Indeed, a number of countries have seen their currencies weaken to the extent that they are even selling reserves into the market. All else being equal, this would imply a need to buy USD against other developed market currencies to maintain portfolio benchmarks.
As Brad Setser would tell you, not else is necessarily equal; a decline in the EUR/USD rate reduces the need to sell EUR/USD via the valuation effect. Still, it is fair to say that the CBs have been refreshingly absent from the G10 foreign exchange market recently; call it addition by subtraction.

SO WHERE TO FROM HERE?

Ah, the million (billion? trillion?) dollar question. At this juncture the list of what Macro Man does not know is substantially larger than the list of what he does, which naturally reduces his confidence in any of the conclusions that he may reach. A useful starting point may be to consider how durable some of the above-mentioned factors may be. Very briefly:

a) Re-coupling. From Macro Man's perch, this set looks to continue, at least within the developed market. It's therefore likely to remain dollar-positive moving forwards.

b) Commodity feedback loop. This could fall out either way. If China cranks up the factories after the Olympics and/or hurricane season is a bad one, oil could be back above $130/bbl before you can say "Sell my SUV." By the same token, if the weather is a non-event and Chinese industrial activity continues to decelerate, we could easily threaten or perhaps breach $100. Confidence is low on this one, but for choice Macro Man would suggest that from here commodities are more likely to be a dollar negative than a positive.

c) Hedging/repatriation. In many ways this is a similar phenomenon to item a), and it therefore seems reasonable to expect it to continue to support the dollar.

d) CTAs. A bridge made of balsa wood provides more enduring support than these chaps.

e) CBs. Macro Man's best guess: they return to market (after all, most of these guys are still running tasty current account surpluses), but with a lower profile moving forward than they've had in the past. The acid test here will be Q4 of this year; for most of this decade, CBs have been very vigorous dollar sellers against G10 in the fourth quarter of the year.

Adding it all up, Macro Man arrives at the conclusion that the buck is likely to be more stable in the future than it has been in the past. He would be very, very surprised if we revisit the dollar's lows against the rest of G10 during this cycle.

A useful historical analogue is USD/JPY in the mid 1990's, which was a seminal event in framing Macro Man's understanding of long-term currency cycles. As readers may or may not recall, the early 1990's saw USD/JPY drop steadily from 160 to 100 by late 1994, and then collapse to 80 in the spring of 1995. After jiggling around the low 80's for a few months, in the summer of 1995 it then surged back to 100 as quickly as it had fallen, which history eventually showed was the initial phase of a new dollar bull trend.

The reversal of fortune in EUR/USD struck Macro Man as exhibiting similar tendencies, but even he was amazed when he overlaid the last few years' price action in EUR/USD with that of USD/JPY in the early-mid 1990's:

The key price action here is obviously the "hump" in the upper-right hand corner, which is remarkably similar in both shape and duration for both currency pairs.

While historical analogue overlays can be over-interpreted, in this case Macro Man believes there is a reason to believe the parallel, as in both cases the dollar has sharply recovered from badly over-sold (and under-valued) levels, thereby dispelling the notion that dollar weakness is a one-way, ever-profitable bet.

Now, the fundamental backdrop now versus the mid-1990's is completely different, so it's unreasonable to expect the analogue to hold tick-for-tick. But the follow through in 1995-96 for USD/JPY- a year of sideways, range-trading, back-and-fill price action- seems to be a reasonable forecast for the next few months and quarters for the dollar.

Whether the buck can eventually rally against the euro as it did against the yen in 1997-98 is another question altogether, and Macro Man suspects that the answer is "no."

The degree to which the dollar can "buck up" from here will, in all likelihood, ultimately depend on the extent to which the US economy and financial system can recover from the current crisis; issues which seem unlikely to see a quick resolution.

Still, the dollar moving from a one-way bet to a two-way bet is a significant change, and one that Macro Man intends to heed in his investment strategy. This month Macro Man has already taken the biggest dollar long bet that he's had in two or three years, and while he can certainly contemplate going short again, perhaps soon, from his perspective the era of the "all-in" bet from the short side is over.

18 comments:

gsm_73 said...

Hello:

Waited for your comment on what happened after Jul 14.
In UAE, Qatar and Oman we saw a sharp sell off in equities with prices of certain scrips falling +25% in two weeks since Aug 1. This was attributed to hedge funds/ foreign investors selling to cover the losses incurred in long commodity/short financial elsewhere. Our markets are normally sleepy during the summer and (forthcoming ramadan in Sep month) but this time we saw sharp fall in indices and in certain scrips which were owned by (and whose price rise was attributed to) foreign institutional (money).
Also I read in FT (quoting EPFR) of outflows from ME and EM funds.

best regards:

ganesh
gsmani@gmail.com

Macro Man said...

GSM, the fact that all of the revaluation expectations in the GCC currencies has been priced out is pretty consistent with foreigners getting out of Middle eastern markets across the board.

Anonymous said...

Seems to me that USD rally was specific to more obviously overvalued pairs, would be curious to hear your yen thoughts given its relative dislocation, and so definitely agree with sideways prognosis unless we see another bank failure (or other catalyst), rumblings of which seem to be increasing post Rogoff article.
Wondering if recent gold related junk posts in your comments are toppish signals, but I note that both XAU/USD and EUR/USD are on or close to major supports.
Think the equity pain trade (i.e. silly intraday moves) may be close to an end as players conclude that we are not out of the bear infested woods economically speaking.
As such I think the most important factor in recent movements has been the re-coupling, which I prefer to think of as more of a catch-up, from other developed markets. Will continue to watch how this plays out in EM.
Cheers, JL

Macro Man said...

JL, my take, per point a, is that the USD moved most against those currencies where CB expectations had moved the most. While there is also a correlation with valuation, I tend to write that down to more of a coincidence than anything else. Given that BOJ expectations didn't really move, it is eminently sensible within my framework that the yen broadly outperformed stuff like NZD, EUR, etc while still participating in the dollar uptrend.

Re: gold, yes the spam is annoying. I can't figure out how to delete it, but I have taken steps that will hopefully prevent it in the future. Who knows whether it represents some sort of turning point; certainly the market scuttlebutt is that gold is flying out of the vaults in Zurich as long term buyers swoop in. Obviously gold is a subject matter that inspires almost religious debate; suffice to say that I'd concur that it could easily bounce from here and yet be lower in a month's time. Like EUR/USD, I currently have no position there.

As for Rogoff, I have to laugh. Financial market participants spend all day looking at screens, reading research, and watching newswires. Yet an academic says things aren't over yet, and somehow this is news. Surely anyone whose job it is to follow markets should know that already?

Anonymous said...

been thinking about fre and fnm--what do you think happens to their debt if they go through the nationalization-and then privatization process--niationalization bit i got but down the road if uncle sam really is able to create some smaller truely private companies to do this job what happens to whatever is left of outstanding fre and fnm paper??? if i was a swf or asian cb think this would be top concern at moment

Macro Man said...

Well, the plan of that chap whose name escapes me is that Agency bond holders would be left with 90% debt and 10% equity in the newly capitalized, privatized FNM and FRE, which would then be left to sink or swim on their own. I have to say that I have quite a bit of sympathy for this outcome, namely that currency piss-takers are presented with a bill for their so-called free lunch.

What will actually happen? I'm not sure. At this juncture a permanent nationalization would be appear very, very difficult, and I'm not sure hoe they could effect a temporary nationalization while avoiding a temporary convergence between Agency and Treasury bonds, which I would presume would be taken as un undesirable outcome (via drastically increasing the outstanding stock of Treasury debt).

Anonymous said...

stephen jen's been useful :P

http://www.morganstanley.com/views/gef/archive/2008/20080801-Fri.html#anchor6719

cheers!

martin said...

New site very much cleaner and more professional albeit type is quite small for these old eyes. Grateful for Firefox zoom feature.

Much appreciate the candid analysis of USD.

Macro Man said...

Martin I am trying to increase the font size but experiencing technical difficulties...hopefully to be resolved at some point today.

Anonymous said...

is it possible that CB intervened?

perfect time for it. everyone was watching Olympic.

Anonymous said...

FNM and FRE will be left on their own after the re-structure? What will happen to the long term rates and housing markets? That got to be pleasant.

David Pearson said...

Martin -- pressing "control" and "+" on your keyboard increases font size.

Macroman -- isn't the fate of the dollar dependent on de-levering by U.S. GSE's and investment banks? The Fed stopped de-levering in March through the new swap vehicles. It began to rear its head again in July, and they tried to stop it with a GSE bail out. Now its back. What will they do to stop it this time? Bernanke's academic work and speeches suggest further rate cuts aimed at goosing base money growth. To paraphrase Ben's life work, there's simply no excuse for stagnant base money in the face of a deflationary threat.

To put it simply, Fed Funds are a function of credit spreads. If they widen as balance sheets shrink, expect the dollar to sink again.

Macro Man said...

OK, think I've got the formatting sorted.

Anon @ 4.38, there has been some mumble about the Fed doing covert intervention, but to be honest if someone had been in, word would have gotten out.

Anon @ 6.11, perhaps they would restrict themselves to fulfilling their chart and not levering up massively. From the consumer's perspective, perhaps first time buyers will no longer be squeezed out by "investors" who secure 100% financing with a no-doc liar loan on the expectation that they'll be able to flip a property in 6 months for a 20% gain.

David, I think the GSEs have, top some extent, been discounted by markets- at least the equity market. I mean, the price of Fred can only go down by another 3 bucks or so.

As for a Fed response, I think it unlikely at this juncture that they'll cut rates again, even if/when Freddie/Fannie/Lehman/Merrill go to the wall. I think a lot of the talk that we've heard over the past few months have been preparing us for that eventuality.

More to the point, I think the Fed has realized that cutting rates aggresively has carried with it substantially negative externalities- namely, a run on the dollar and an income-squeezing uber-rally in the commodity/energy complex.

And really, base money grwoth hasn't done a whole lot despite the rate cuts, for the simple reason that the Fed hasn't expanded its balance sheet. It's merely shuffled the mix on the asset side, replacing holdings of Treasuries with holdings of turds.

I suspect the next step for the Fed in the event of financial market stress would be to expand its balance sheet; to wit, increasing the liability side of its balance sheet by printing money to pay for the turds that they buy.

While this should indeed be bearish for the dollar ultimately, it's unlikely to have the same short-run impact as rate cuts. And really, it's only bearish for the buck if those dollars make their way into overseas investments. Any circumstances that would require a balance sheet expansion would, in my view, likely result in cash hoarding, so the dollar effect would be mitigated. If anything, such circumstances may encourage or speed the nascent trend towards repatriation of assets/hedging of (currency) risks that seems to have supported the USD this month.

Anonymous said...

Terrific discussion and great, clean new site design. Re the USD, I hae a lot to learn, but has the strength been consistent weith levels of national debt ( high) and five-year growth outlook ( low)? Glad to have you back in business, MM. Best-- Anon

David Pearson said...

Macroman,

I agree base money growth has been stagnant. I think BB would look at this as the same mistake that BOJ and the 1930's Fed were guilty of. But then we agree overall, as I believe balance sheet expansion is THE way to get base money growing, and not interest rate cuts. As you imply, the key is the effect of balance sheet expansion on velocity. In a Brazil/Arg. scenario, the money flies out the window, but in yours it gets put in a mattress. I'd argue the former is more likely, but I can see your point.

BTW, you can't have Fed liabilities expand without cutting rates in a rate targeting regime -- to keep the rate at target, the Fed would have to withdraw the liquidity. That's why rate cuts are an ancillary part of quantitative easing.

Boat52 said...

Macro Man's posts are better than strong black coffee first thing in the morning to get one's brain waves in action.

This website is truly a valued gem.

Anonymous said...

MM - one thing that stood out for me as a possible difference between EUR/USD now and USD/JPY in 95 was the lack of a single, credible figure really jawboning the dollar back up when the move got extreme.

In 95, Sakakibara seemed to be on the wires on an intraday, never mind daily basis. He would say that he thought the move was overdone, suggest a more 'sensible' level and bingo, the market would gap right through it a couple of hundred points. At which point he'd act kind of embarrassed, as if he hadn't meant to have that effect. Then 24 hours later he'd do it again.

Whereas now we have comments from the ECB in the (London) morning contradicted later on by the Fed, or in some cases Fed members even contradicting each other. Not sure if that's relevant or not, but as a youg junior back in 95 it definitely felt to me like Mr Yen was a big part in that dollar reversal.

SD

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