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Thursday, July 10, 2003

USD Correction Entering New Phase?

MS's Stephen Len argues that the USD correction is now entering a new phase. If the first phase was characterised by a change above all in USD-euro values, and to a lesser extent USD-yen values, the next phase should centre on a correction with the remaining currencies (which depends in the end on whether or not the Chinese are prepared to play ball: this has to remain an open question). His reasoning here, the inherent weakness of the eurozone economies:

The single-most important development in the currency markets is the rapid deterioration in the outlook of the Euroland economy in the last two months, in my view. While the USD side of the story is by and large unchanged from two months ago, it is becoming increasingly clear that Euroland does not have the tolerance for a sustained overshoot in the EUR. The rally in EUR/USD was too rapid for the policy makers in Euroland to reverse their long-standing position that the EUR was grossly undervalued. However, with growing evidence of the Euroland economy in atrophy, I believe the Euroland policy makers will quietly welcome the recent correction in EUR/USD. In fact, the lack of complaints from Europe so far against the recent correction in the EUR essentially signals, in my view, that the Euroland has involuntarily joined the ‘war of competitive devaluation’. EUR/USD is no longer the ‘path of least resistance’ in the USD index sell-off. With the EUR no longer strengthening against the USD or JPY, downside pressure on the USD will be forced out via the Asian and emerging markets.

I cannot over-emphasise the importance of making a clear distinction between the USD index and EUR/USD. Some investors still, surprisingly, treat them as synonymous. Just because I’ve declared that the structural ascent in EUR/USD may be over for the year does not mean that I believe the USD correction is complete. I stress again here that I believe the correction in the USD index (measured by the Fed’s major currency index) still has some 5-10% to go by end-2004, but the adjustment against the EUR is now complete. (Compared to the expected fundamentals in 2004, the USD index is 5-10% overvalued. But compared to the current economic fundamentals, the USD index is only 2-3% overvalued. The main reason why the size of the overvaluation is so modest is because the US still commands a productivity premium over the rest of the world, which partly offsets the record size ‘twin deficits’. Those who are fixated on the US’s C/A deficit miss this important point.) The capping of EUR/USD and EUR/JPY will partially correct the skewedness of the current correction in the USD, pushing more USD downside pressure out against the JPY than the EUR. This is why I believe that, in its final phase of correction, we will see more of a rotation of leadership from the EUR to non-EUR currencies. In my view, the USD will correct mainly against (1) commodity currencies, (2) LatAm currencies, and (3) Asian currencies

But Len goes further, and in so doing locks swords with his boss, Stephen Roach. In Len's view a number of points are important: that global deflation and a US dollar crash are incompatible, that the US 'productivity advantage' still makes it a superior destination for investment and that thirdly the 'symbiotic' US-Asia relationship isn't going to change dramatically any time soon. For these reasons, and despite the existence of important structural imbalances, he argues that the conventional currency view is not applicable, and that the USD is liable to much less downside risk than many imagine. I broadly agree, indeed my feeling is that, with the euro position unsustainable and the Chinese in no hurry to float significantly upwards, the risk is if anything upwards in the mid-term.

In his Forum dispatch on Monday, titled, ‘Flashpoint?’, Steve argued that the continued expansion in the US savings deficit, and therefore the goods market imbalances, will need to be normalised through a massive and sharp decline (i.e., another 30-40%) in the value of the USD. This is an important view, one that challenges the very foundations of my view on the USD. I respond with the following points.

Point 1. Global deflation and a USD crash are mutually exclusive. The primary difference between the current situation and the mid-1980s is that we are in a synchronous global recession. At this point, fighting global deflation remains a top collective objective of global policy makers and one that is significantly more important than re-balancing global demand. Despite the widespread criticisms of the imprudence of the US consumer, no one in the world genuinely wants to see the US consumer stop consuming, as that would very likely lead to a global recession. Asia has already shown its hand in not wanting to see its currencies rally against the USD. But with the Asian currencies (not just the Chinese RMB, but also the JPY and the rest of Asia) therefore effectively pegged to the USD, a sharp crash in the USD would be extremely deflationary for the rest of the world (i.e., Europe and emerging markets). It is thus difficult for me to see how the USD can crash if the rest of the world will not let it crash. If anything, the US, Euroland, Japan, China, and the rest of Asia are already fully engaged in a war of competitive devaluation.

Point 2. The US is still a superior destination for investment. Notwithstanding all the criticisms of the US policies, the US remains one of the most flexible large economies in the world. I am not at all convinced that the expected return on assets is higher in Euroland or Japan than in the US. After 9/11 and the war in Iraq, there was also much speculation on whether the USD had lost its shine as the geopolitical hegemonic currency. It is interesting, anecdotally, that Saddam Hussein paid hired foreign combatants in US dollars, not the EUR, not the Russian RUB, and not the JPY. Even given more reserve currency diversification, in my view we have to accept the fact that the USD is still the hegemonic currency in the world, and will remain so for a long time.

Point 3. The symbiotic relationship between Asia and the US will last for a while. Asia’s recycling of its balance of payments surpluses back into US Treasuries through intervention is a reflection of a lack of confidence in letting the USD weaken against their currencies. One day Asia will find a better balance between consumption and production. In the meantime, however, Asia’s ‘lack of confidence’ and under-consumption imply that the US will be allowed to run persistent current-account deficits, with much less downside risk to the USD than a more orthodox view on currencies might suggest. LINK

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