Archive for August 24th, 2008

August 24th:

*Actual results may differ.

Chris, your noble Economic Equity…ist .. has asked me if I’d care to write something in his stead – a kindness to which I am not unresponsive. However I no longer teach Economics: I’m a fully-fledged Health Economist again, in another country, and I take no responsibility for knowing what I’m talking about. I’ll probably also only do this in one draft.

Specifically, he asked what I thought of the new strength of the of the US dollar, given my ongoing classroom criticism of the US dollar, and my predictions of it’s decline. So here’re a couple of pictures worth a quick couple of thousand words (Chris can fix the formatting):

What’s our narrative? Besides poetic justice to ‘the speculators’ and a reminder that money, invariably, passes from the hands of the speculators, the dilettantes, the under-prepared managers of their own life’s savings, the managers of public pension schemes … into the hands of investors.

Don’t believe me? Go to vegas, sit down at the table of unsmiling heavy-set gentlemen who look like they’ve lived there their whole lives. See how you get on.

The real question is, is the US economy storming back? Will Bush turn out to have been right all along? Will Bernanke and Paulson turn out to have been the best type of idiots of all: the idiots savant?

No. Of course the answer is no. Nobody wastes their time with rhetorical devices.

This resurgent dollar story is, sad to say (with sincerity), a story not of the new strength or resilience of the US economy, but the wobbly legs and knees of the UK and Europe (if you’ll forgive my dichotomising them). It is the story of the UK and European economies catching up to the US in the doldrums, as they surely would.

I stress the surety of their joining you because, typically, another narrative is out there: one in which the red, white and blue greenback can’t be given a black eye. The Financial Times, in fact, managed to cover nearly every base in their reporting of 8 August, this year:

The moves marked a key reversal of a trend that many investors had followed profitably for months – betting that high commodity prices would keep the dollar weak.

“This is the watershed week for the US dollar,” said Marc Chandler, currency strategist at Brown Brothers Harriman. “The magnitude of the dollar’s moves and the breaking of key technical levels suggest that a major shift in the outlook towards the dollar is occurring as massive positions are adjusted.” Other analysts described the widespread buying of dollars as “capitulation”.

Traders said the violence of the move was testimony to the extent to which the market had been surprised by economic weakness outside the US.

“Mr Trichet was unable to convince the public that the ECB had not been surprised by the Eurozone’s economic downturn,” said Ulrich Leuchtmann at Commerzbank. “Therefore, the last remaining rate hike expectations were taken off the table.”

UK economic data has shown increasing weakness this week; officials in Japan warned that the economy was headed for a recession; and the Reserve Bank of Australia said it was planning to start cutting interest rates to head off an impending economic slowdown.

You can look, yourself, for others. I don’t have the inclination to do harm to my own psyche. I will say, however, that this is not a knock on the US or US media: you’ll find it all over.

First, the weakness of the dollar has been driving up commodities, not the other way around. Now, if one invests not according to fundamentals but according to an eye for increasing prices (even on stocks or goods that are overpriced already) then one is basically watching, always, for the realisation of that gain – not to mention the first sign of a peak. So (i) the big ‘other’ economies falter, (ii) their future GDP looks weak relative to yesterday’s comparison with US GDP, (iii) returns on your investment won’t be so high, therefore (iv) it is time to move your investment.

Why, one might ask, did this not simply push commodities higher still? If people fled the US dollar for oil and gold, why would other people not flee the Pound and the Euro similarly? Partly because the gains were already made, mostly because – I suspect – we’re not talking about speculators, we’re talking about investors, who buy and make capital gains (remember those types?) and people who need to hedge in currency.

It’s also, as any first-year student and reader of the Economist magazine’s Big Mac Index can tell you, the simple, clean and ruthless crunch of Purchasing Power Parity, Interest Rate Parity (which had been behind the initial decline in the value of the greenback. We’ll return to this) or any other kind of parity you like. International currency arbitrage is a force to be reckoned with, and it enforces equilibria faster, possibly, than anything else.

When the UK and Eurozone economies stop being bigger, better, stronger than the US economy, so do their currencies. It’s that simple. The US dollar did not appreciate because the US economy is doing well. A sinking tide lowers all boats, too.

So. Having bashed up the US enough to secure a by-line at the Exile, let us return to economics.

We know – let us assume – that, in the event of declining economic activity and macroeconomic contraction, monetary policy responds by lowering interest rates. Lower the official rate of interest: increase borrowing, increase investment, increase consumption, increase jobs; problem solved.

However, interest rates – broadly speaking, now – are not just the cost of borrowing, they are the returns on lending. So if you’re an investor (say, Warren Buffet, or China), you’ll think twice about leaving your money in that economy. You’ll look at another economy.

This is the cause of the declining value of the US dollar, way back when. The US economy, rightly, faltered first – and how. With no fiscal policy upon which to draw, Bernanke got it all with not even a blindfold to keep him company. Rates were slashed, time and again. Meanwhile, the UK, Europe and any number of other economies were (i) not faltering, yet, but as importantly (ii) more concerned with inflation which, while still measured dodgily and with political expedience in mind, is nevertheless still measured more accurately, and taken more seriously, everywhere better than in or by the US.

As of recently, however, such is not the case. Despite the best of intentions, my copy of the FT Weekend loudly declares the UK economy to be at a standstill (“UK economy shudders to a halt”, I believe, is the phrase employed). The Eurozone economy (if you want to kill some time, narrow it down: look up Italy, or Germany) likewise.

The FT’s quote above had Trichet being caught unawares. As the author of this august blog can tell you, I’ve yet to buy into the argument that such people truly can be caught unawares (seriously, give me a break). However, if ‘the market’ is anticipating an interest-rate hike and, instead, gets talk that sounds more like rates will be held or, maybe, lowered, it’s time for that Interest Rate Parity to take hold.

Thus my argument. The US dollar is not appreciating in value because it is normalising upward: it is appreciating because the rest of us are normalising downwards, and don’t let anybody tell you otherwise.

So what does this mean for us? Most likely it means that there’s a decent chance that the US economy will lead us out of these same doldrums. There’s also a decent chance that it won’t: the problems began in the US and the ability to re-start half-intelligent regulation is hindered more in the US. But the US is the OECD’s dynamo.

This is only another bear market rally: play it only if you have the time, the nouse and the willingness to lose your pants by making a wrong bet. It doesn’t mean one shouldn’t look out for the real recovery, though. Look out for it. Buy the dollar, if you like gambling, then sit tight for a couple of months and buy the Pound/Euro when it reverse the process currently underway. Then send me my cut.


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