How The US Dollar Staged An Incredible Comeback And Humiliated The Doomsayers

Business Insider

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dollar comeback

Rob Wile/Business Insider

The U.S. dollar is back!

Thanks to a U.S. economy that is outperforming its peers in the developed world, an improving energy trade balance spurred by a domestic energy boom, and a shifting interest rate environment, market practitioners are coming around to the notion that the dollar is poised to enter a new bull market.

However, it wasn't always so.

While concerns about the demise of the dollar are nearly as old as the Republic itself, it was only recently that people were seriously freaked out about the dollar's weakness, and the end of its global dominance.

The dollar's long decline

In 2002, the U.S. dollar index peaked, subsequently losing 40 percent of its value over the next nine years.

Some of the first dollar-death calls came amid an era that saw two costly wars initiated in the Middle East and big tax cuts by President George W. Bush, both of which helped to send U.S. deficits skyrocketing.

A typical  analysis of the situation from the BBC , written at the height of the Iraq war, did not fail to mention these factors.

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Global central bank currency reserves

JPMorgan

Meanwhile, the euro was rising.

It had been introduced only a few years before, in 1999, and for the first time, there was perhaps to be a real alternative to the dollar as a global reserve currency.

Global central banks, therefore, began diversifying away from the dollar in favor of the euro.

Even rappers became involved in the unfolding story.

The infamous video for Jay-Z's 2007 single, "Blue Magic," includes a depiction of a stack of euros being counted. 

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jay z blue magic euros

Youtube

Screengrab from Jay Z's "Blue Magic"

The Associated Press interpreted the imagery thus: "Jay-Z's new video for 'Blue Magic'  seems to attempt to acknowledge the dollar's decline in an ironic way and to paint the artist as an international hustler who is smarter than those accepting greenbacks."

"When the [Federal Reserve] was running really easy policy from 2003, the rest of the world wasn't, so being a dollar bear seemed obvious," Société Générale currency strategist Kit Juckes told Business Insider.

The first abrupt changed came in 2008, though.

Markets crashed in the wake of the collapse of Lehman Brothers, sending investors fleeing to the U.S. dollar for safety as part of the biggest "risk-off" move in modern history. It was evidence that in a panic, the world still craved greenbacks.

However, the strength in the U.S. dollar index was short-lived, as by early 2009 investors were moving back into stocks, and the dollar continued its downward trajectory as "risk-on" sentiment returned.

It got so bad that in 2009, Time Magazine  twice asked  whether it was “dying a slow death.”

“In 10 years' time it won't be such a dollar-dominated world. I'm sure of that,” Harvard economic historian Niall Ferguson told the magazine.

Then, everyone else started doing way worse.

"Sovereign credit worries in Europe and Japan are leading to some general risk aversion," an analyst  told Reuters in March 2010  (a prescient description of what was to come in the next few years) .

The euro area became embroiled in what has at times been a rather terrifying crisis, and emerging markets felt the painful effects of euro-zone bank deleveraging. Japan has struggled with nonstop political instability, not to mention a massively disruptive earthquake and nuclear disaster.

The big turn upward

While the post-crisis recovery in the United States has been tepid by historical standards, it's clearly done well when compared to the world's other developed economies.

Now, everyone seems bullish on the U.S. dollar and is calling the big turn upward.

Of course, even though the general perception in the American psyche after a decade-long decline in the value of its currency is one of dollar weakness – after all, it's been a long way down – this upward turn isn't actually a brand new development.

In fact, according to Marc Chandler, head of currency strategy at Brown Brothers Harriman, "the bull market in the dollar began several years ago."

"The thing is that the dollar bull market is well entrenched," Chandler told Business Insider. "You might have just discovered it – some people on Wall Street might have just discovered it – but it's been underway for years."

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EUR/USD and GBP/USD

Bloomberg, Business Insider

The chart at left shows what Chandler is talking about. The British pound sterling peaked against the dollar in 2007. The euro peaked against the dollar shortly thereafter, in 2008.

The Japanese yen is the last major currency to top out (against the dollar), but since September, it's turned down decisively, and many expect the yen's tumble to continue, thanks to a new government that seems committed to taking extraordinary monetary measures to weaken the currency.

The latest development everyone is so excited about

The chart that has everyone buzzing in the last few weeks, though, is the one below, which shows an important change in the behavior of the dollar at home.

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Morgan Stanley

Only recently, the dollar has become positively correlated with risky assets like the U.S. stock market, reversing the relationship that has governed the relative performance of the two asset classes for a long time.

(This positive correlation isn't unprecedented, but it hasn't really been observed sustainably since the 1995-2000 period.)

Can the stock market and the dollar really rise in unison, though?  What exactly is happening here?

The rise of the American economy and its energy future

In a recent report, SocGen's Kit Juckes wrote, " We are leaving ‘risk-on/risk-off’, and entering an age where growth determines FX performance."

If that is the case, it's good news for the U.S. dollar. The U.S. economy now stands out as the clear growth leader in the developed world. Just look at the data out of Britain (the pound sterling is certainly paying for it), the euro zone, and Japan (even China is seeing fresh new growth concerns).

Aside from an improving labor market (compare with the euro zone, where unemployment in many areas is still spiraling out of control) and a recovery in manufacturing, there is another bright spot in the U.S. economy that other countries can't claim – a nascent boom in domestic energy production.

SocGen currency strategist Sebastien Galy told Business Insider that this development on the energy front is "a fundamental shift...in the balance sheet of the U.S. which determines its credit-worthiness in the eyes of long term investors."

David Woo, a rates strategist at BofA Merrill Lynch, penned a big report this week explaining the mechanics behind the U.S. energy boom's supportive effect on the dollar.

The gist of it is this: U.S. energy production has surged in recent years. At the same time, consumption has flatlined. Naturally, this means America's trade balance – driven by the energy component – is improving.

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US, Japan, Europe petroleum trade balances

BofA Merrill Lynch Global Research

In contrast, energy trade balances in the euro area and Japan continue to get worse.

The rise of Chinese energy consumption has driven oil prices up. When the U.S. was more dependent on imports for oil, rising oil prices meant the dollar weakened. Now that the U.S. is becoming less dependent on oil imports, that negative correlation between oil prices and the U.S. dollar is fading away.

"Going forward, it will be Europe rather than the U.S. that will have to bear the brunt of the cost associated with the growing number of Chinese and Indian consumers and their appetite for energy," writes Woo.

In Britain, the trend in the petroleum balance is similar to that in the euro zone and in Japan.  These developments on the energy front are thus good for the value of the dollar and bad for those of the euro, the pound, and the yen.

The "Great Rotation"

In addition to the energy boom, there is another compelling catalyst for dollar strength on the horizon in the United States.

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Great Rotation equity bond fund flows

As of November 2012. Click to enlarge

U.S. Treasuries appear to be closing in on the end of a 30-year bull market rally. In just the last few years since the market peaked in 2007, hundreds of billions of dollars have flowed into bond funds while equity funds have suffered massive outflows.

Many analysts expect this trend to reverse as the U.S. economy strengthens. The idea is that perhaps in late 2013 or sometime in 2014, investors will begin to re-allocate a significant portion of their portfolios from bonds to stocks.

This, of course, means rising interest rates from their current ultra-low levels, and that will make dollars more attractive relative to other developed-market currencies for international investors seeking yield opportunities.

"Abenomics" and the Japanese yen

The yen, on the other hand, is undergoing a shift in the exact opposite direction. After years of stubbornly high real interest rates, the new monetary regime spearheaded by Japanese Prime Minister Shinzo Abe is finally forcing them downward.

In recent years, investors piled into yen as a safe-haven currency, helping to drive up its value. Now, with the yen expected to weaken dramatically (and in fact, it already has weakened substantially since September), there is talk of the yen returning to its old role as a funding currency.

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USD/JPY and interest rate differentials

Deutsche Bank, EcoWin

Click to enlarge

In other words, investors are starting to consider the prospect of borrowing yen in order to fund purchases of higher-yielding currencies.

Deutsche Bank strategist Bilal Hafeez notes in a recent report that interestingly, during the three major turns in the U.S. dollar since 1995, the USD/JPY exchange rate has always been one of the last currency crosses to confirm the big change in trend.

That seems to be happening again now.

Therefore, Hafeez thinks the yen's stunning slide against the dollar in recent months is a big deal. He writes :

The significance of the USD/JPY turn higher should not be understated. It is perhaps the only currency pair that has captured all the major macro themes since the 2008: an aversion to crisis-prone regions, ultra-easy Fed policy, the Euro-area crisis, and the investment boom in China. All these have until recently been positive for the yen against the dollar, and indeed contributed to the all-time high seen in the yen. The fact that the yen has now so decisively turned lower suggests markets are entering a new regime.

The notable shifts in market behaviour include the complete breakdown of the relationship between relative interest rates and USD/JPY and the declining correlation between the dollar and equities, such that the dollar is no longer weakening in “risk-on” periods. 

When you put it all together, the reasons why it's hard to find anyone betting on the euro, the yen, or the pound at the moment become clear.

Naturally, the opposite is now true for the dollar.

" It’s the default long among the majors already," Deutsche Bank strategist Alan Ruskin told Business Insider.

Galy agrees. "Lack of better choice is helping to boost the USD as investors assess their risk return ratios," he said.

Reservations

What about quantitative easing, though? The Federal Reserve is still buying $85 billion of Treasuries and mortgage-backed securities every month, and it doesn't look like the central bank is planning on easing up any time soon.

Of course, with currencies, it's all relative. 

"Some people who are bearish on the dollar talk about quantitative easing as if the currency market is just driven by one factor – monetary policy," Chandler says. "But even if you want to think the currencies are driven just by monetary policy, I would look at the balance sheets of [central banks in] other countries."

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Comparative central bank balance sheets

Deutsche Bank, EcoWin

A look at some of those balance sheets reveals that the Fed's – relative to GDP – isn't as big as those of others.

One important observation here, though, says Ruskin, is that the " ECB balance sheet is shrinking, and shrinking sharply relative to the Fed balance sheet." If this continues, it could certainly restrain the rate of dollar appreciation.

However, given the state of the euro area economy, ECB monetary policy is expected to remain accommodative for an extended period of time.

"Even though Fed tightening is still a long way off," says Juckes, "it's much closer than ECB or BoE or, most of all, BoJ tightening."

All of this means that the recent recoupling between rising U.S. stocks and a rising dollar could be a sign of something new. 

Citi strategist Steven Englander is not convinced, however.

"I think the jury is still out on the USD," Englander told Business Insider. "I am surprised at the pro-risk USD correlation, and do not discount the possibility that it will continue, but it still seems fragile."

Englander says this particular dollar rally is missing that special something evident in previous bull markets:

The positive correlation with risk over the last two months is unusual but not unprecedented. The USD is more typically a safe haven currency. When we have had big USD-positive rallies in the past, it has been because there was a U.S. asset that was uniquely attractive, such as real Treasury yields during the Reagan rally or high tech during the internet boom. 

Now, we have a weaker form of USD uniqueness. Despite long-term concerns on U.S. fiscal and monetary policy, we are getting short-term outperformance in the U.S. economy and asset markets. This is largely because EM is treading water and the rest of G4 is in pain, but it is real outperformance nevertheless that makes the USD attractive.

This may continue, but does not make the USD the blinding buy of the early 1980s or late 1990s, keeping in mind that our macro policies leave something to be desired. Moreover, the USD bounce does not seem structural, and could be turned around by other regions gaining traction. 

Tax reform, entitlement reform, or energy independence would be structural, but we are not there yet. Hence my view that for now there are better themes to focus on (short GBP, short JPY and keeping an eye out for a potential EM rally).

Nonetheless, the current tone toward the dollar is quite bullish.

"A ll currencies appear to have peaked against the dollar from a purely mechanical perspective," Hafeez writes in the Deutsche Bank report. " If anything, we risk underestimating the extent of dollar strength in coming years."



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