The dollar is an extremely misunderstood creature. Just from listening to TV and reading in the press over the past week, I have run into comments about the dollar, spoken with great conviction and repeated frequently, that don't pass the smell test.
Here's a short list:
Flight to quality. How many times have we heard that phrase when the dollar rises as equities sell off, as we saw late last week? However, you have to stop and ask yourself, if the decline of the dollar and the deterioration of the economic fundamentals in the U.S. are the very reasons for the generalized risk-aversion, as has been the case of late, why would "flight" into dollars be "quality"? Doesn't make sense, does it, especially when "everyone" agrees that the dollar's fundamental weakness is because of the U.S.' "twin" deficits?
Of course it doesn't. The reason the dollar tends to rise when markets experience high levels of risk-aversion is very simple: Investment funds all over the world are predominately denominated in dollars, especially hedge funds. When portfolio managers start to lose money beyond a certain level, they reduce risk. This means getting flat, going home, selling whatever it was that you were in, buying dollars and getting closer to cash or to your benchmark.
Why haven't people caught on to this? The reason people still say "flight to quality" is that we in the market are slow to recognize paradigm shifts. Our analysis tends to be hindered by excessive reliance on the rearview mirror -- for example in taking some five years to recognize
the positive -- not negative -- correlation between the price of oil and the
, because in previous oil crises the relationship was indeed negative.
The Fed is deliberately debasing the currency. Lowering rates, it is argued, means pumping money into the system, and the faster growth of the dollar money supply relative to other money supplies induces depreciation of the dollar. I understand the risks of saying anything that is not unambiguously negative about a government entity, but this Fed-bashing sound bite has two problems, one factual and one conceptual.
The fact is that base money -- the element of money supply that central banks control -- has been growing faster in Europe than in the U.S.
for the past five years
. So you can hardly accuse the Fed of deliberately debasing the dollar with the printing press and/or helicopter drops.
Second, it is not necessarily the case that lower interest rates mean the money supply is being massively increased. The other side of the equation is demand, and under the right conditions, if money demand is contracting fast enough, you wouldn't need to see much of an increase in supply at all to hit a lower interest rate target. For example, the Fed cut rates dramatically in 2001, but money supply fell because demand dried up in the aftermath of the tech bubble's bursting.
The strong dollar policy. In short, there is no strong dollar policy. Never has been. There has only been strong dollar rhetoric. It is hard to convince market participants -- a number of whom, I suspect, also believe there is a government committee that props up the stock market in dramatic moments -- that this is not the case. But apart from the rare occasion when the G-7 has coordinated interventions to temper extremes of one sort or another, U.S. administrations of both parties over the years have basically believed in a fairly valued, market-determined exchange rate. They are forced to reiterate the strong-dollar mantra for public, because no Treasury secretary dared move away from it, lest they roil the markets. (This is not entirely true. It was tried at least once that I know of-- by Lloyd Bentsen -- and it created huge short-term volatility.)
Moreover, it is hard, if not impossible, to point to any action the U.S. has ever taken to strengthen the dollar. But watch this space. If
the structural story continues to play out in further dollar declines, the authorities in Washington may soon be forced to start thinking outside of this longstanding box.
There is no dollar overhang. Some have argued that if one takes the U.S. share in the global economy and add to it the share of the de facto dollar bloc countries, then the share of central-bank reserves held in dollars as a share of all reserves looks about right. Therefore, there is no dollar overhang. This misses the point on two counts.
One, central banks are only a part of the puzzle, and a shrinking one at that. It is in the private sector where you find companies and individuals that are uncomfortably long dollars and doing something about it. Second, the share of reserves held in dollars or the percentages of international transactions in dollars is not the analytically relevant question.
dollar bloc is shrinking, and little by little, transactions are moving away from the dollar and into local currency or a non-dollar third-party currency. And those who travel the world and/or have friends outside the U.S. know this is a trend, not a short-term fluctuation.
Still the best reserve currency in the world. One hears this frequently, and from it we are supposed to conclude that there is no structural issue behind dollar weakness. And, as judged by the classic criteria of unit of account, store of value and medium of exchange, the assertion is factually correct. But again, this not analytically helpful: A currency is a relative price. The dollar is, at the margin, little by little, becoming less attractive relative to many other currencies -- either because of the large existing holdings already in dollars and value in diversification, or because these other currencies have become more trustworthy. Just because you are the best doesn't mean others aren't catching up.
In sum, the dollar is dealing with structural issues, as
detailed here, but it is really cheap and really oversold. Jim Cramer is fond of saying it's not enough to short a stock on the basis of its valuation; you need a spark, a catalyst. Same thing goes for buying a cheap currency or shorting an expensive one. Momentum tends to take things farther than any of us think reasonable. Currencies have an additional problem: Valuation is much, much more subjective than it is with stocks, for which at least have a book value.
So even though many of the ingredients are there for a countertrend rally in the dollar, and the risk-aversion we saw in recent days provided at least a short-term spark, a longer-term rebound in the dollar is by no means a given.
Mr. Dow is a portfolio manager at Pharo Management LLC, a Global Macro hedge fund with an Emerging Markets focus. Prior to joining Pharo, he was a portfolio manager at MFS Investment Management, where he managed a variety of fixed-income funds, with special emphasis on Emerging Markets. Previous to that, he worked as an Economist at the International Monetary Fund and at the US Department of the Treasury.