“Logic” Returns to the Forex Markets, Benefiting the Dollar

1. APreviously, the markets had been dominated by the unwinding of risk-aversion, whereby investors flocked back into risky assets that they had owned prior to the inception of the credit crisis. During that period, then, all positive economic news emanating from the US was interpreted to indicate a stabilizing of the global economy, and ironically spurred a steady decline in the value of the Dollar. On December 4, however, investors abandoned this line of thinking, and used the positive news as a basis for buying the Dollar and selling risky currencies/assets.
   If you look at this another way, it reinforces the notion that investors are paying closer attention to the possibility of changes in interest rate differentials. The fact that the recession seems to have ended suggests that the Fed must now start to consider tightening monetary policy. This threatens the viability of the US carry trade – which has veritably dominated forex markets – because it literally increases the cost of borrowing (carry): “If the market thinks that Fed rates are about to move higher, the dollar will cease to be a funding currency and the inverse correlation between the dollar and risky assets will break.”
   To be fair, it will probably be a while before the Fed hikes rates: “It’s a prerequisite to have a continuing decline in the unemployment rate for at least three months before the Fed considers tightening,” asserted one analyst. At the same time, investors must start thinking ahead, and can no longer afford to be so complacent about shorting the Dollar. As a result, emerging market currencies probably don’t have much more room to appreciate, since the advantage of holding them will become relatively less attractive as yield spreads narrow with comparable Dollar-denominated assets.
   To be more specific, investors will have to separate risky assets into those whose risk profiles justifies further speculation with those whose risk profiles do not. For example, currencies that offer higher yield but also higher risk will face depressed interest from investors, whereas high yield/low risk currencies will naturally greater demand. You’re probably thinking ‘Well Duh!’ but frankly, this was neither obvious nor evident in forex markets for the last year, as investors poured cash indiscriminately into high-yield currencies, regardless of their risk profiles.
   To be more specific still, currencies such as the Euro and Pound face a difficult road ahead of them (as does the US stock market, for that matter), mainly due to concerns over sovereign solvency. (Try saying that three times fast!) On the other hand, “Commodity-linked currencies such as the New Zealand, Australian and Canadian dollars [have] rallied sharply, and will probably continue to outperform as their economies strengthen and their respective Central Banks (further) hike interest rates.
   It remains to be seen whether investors will remain logical in 2010, since part of the recent rally in the US Dollar is certainly connected to year-end portfolio re-balancing and profit-taking, and not exclusively tied to a definitive change in perceived Dollar fundamentals. Especially since they remain skittish about the possibility of a double-dip recession, investors could very easily slip back into their old mindsets. For now, at least, it looks like reason is in the front seat, making my job much less complicated.
   As I outlined in my last two posts, the Dollar could witness a rapid appreciation if/when the Fed finally raises interest rates. Given Chairman Bernanke’s frequent erring on the side of inflation, however, it could be months (at the earliest) before the Fed actually pulls the trigger. With forex markets guided by interest rate differentials, and traders’ uncertainty about the timing of interest rate hikes, its fair to say that the Dollar is at a crossroads.
   Currently, the case for an interest rate hike (as the Fed confirmed this week) remains weak: “They will need to see a lot more, better numbers consistently, not just for one or two months, before they would start to genuinely be talking more hawkish…I think the markets may be disappointed if they’re looking for hints of hikes coming soon,” said one strategist. While the data continues to improve – witness last week’s miracle jobs report – it has not yet been demonstrated convincingly and unequivocally that the economy has exited the recession. There are too many contingent possibilities that could send the economy into relapse for the Fed to even consider acting. As I said in my last post, I don’t personally expect a rate hike until next summer.
   Still, the markets are alert to the possibility. And where perception is reality, any sniff of rate hikes is enough to send the Dollar soaring; it has risen an impressive 5% against the Euro over the last couple weeks. That investors are acting so early to protect themselves against a possible rate hike shows the precariousness of the foundation on which the Dollar’s rise has been predicated.The consensus remains that neither the Dubai nor Greece episodes signals broad systemic risk, and that the Fed probably won’t hike rates for a while. Still, investors must brace themselves for the possibility of surprise on one of these fronts, or from a completely unsuspected “bolt from the blue” as one analyst put it, because of what happened to the Dollar after Lehman’s collapse in 2008. As evidenced by the Dollar’s sudden turnaround in the last couple weeks, this kind of uncertainty is self-begetting. As some investors get nervous and begin to unwind their carry trade positions, other investors also begin to move towards the exists, lest they get stuck short the Dollar after the music stops (or when it starts, depending on how you look at it.)
   In that sense, the best paradigm for analyzing the Dollar is the end of the carry trade on one hand, weighed against the possibility of interest rate hikes on the other hand. “The dollar will depreciate to $1.55 against the euro by March from $1.49 last week, and to $1.62 by June, according to JPMorgan,” which is betting heavily that investors will remain clear-headed about interest rate differentials. Those that are looking at the Dollar from a risk-aversion/carry trade standpoint have slightly different projections: “I wouldn’t surprised if the euro makes it to $1.40 before the end of the month without much trouble, maybe a little bit lower.”
   In short, in forex, it’s never enough to be able to predict the economic future. Instead, you must be able to predict how these predictions will be syncretized into currency valuations by the markets. In this case, that mAeans you need not necessarily be able to accurately predict when the Fed will hike rates; rather you need only be concerned with how other investors view that possibility, and whether that makes them feel more or less confident about holding certain currencies