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“The biggest category of contingent debt is made up of the various guarantees the eurozone has been handing out in the last couple of years. European Union governments have effectively guaranteed the liabilities of their entire banking sectors. They have guaranteed all bank deposits up to a certain limit. The eurozone member states have guaranteed Greek debt for three years, and they extended the scheme to the rest of the eurozone. And those guarantees will probably have to be doubled again.”

                           Wolfgang Münchau

FX Trading – Finally we are getting some real company on our dollar call

  • The dollar will probably become a “growth currency” during the next 10 years, shedding its haven status of the past decade, as the U.S. economy outperforms Europe and Japan, according to UBS AG. (Bloomberg)
  • Comment: Welcome to the club, UBS. We have been singing this song since late last year. In fact, a multi-year dollar bull market call, which we have shared here, is one we saw as very similar to the 1992-2002 US dollar bull market.

Below is from our January 18, 2010 Currency Investor issue: The Case for the Multi-Year Bull Market in the US Dollar. Besides doing some bragging, we think the key points made in this issue are still quite relevant. Just to set the stage, the US dollar index was trading around 77.06 then; euro-usd was around 1.45.

Many are afraid the dollar is overbought and the run is done. No doubt, we will see ebbs and flows. But long-term, we haven’t seen capitulation yet to this dollar move. Consider all of these groups that still believe the dollar is doomed:

  1. Newsletter writing nuts and lemming followers who have been crushed by that call, who still make the case: The dollar will go to zero at “anytime now” and be replaced by: a. Amero, b. Yuan, or c. Euor, or d. it doesn’t matter the dollar is doomed
  2. Gold bugs who know that gold’s rally means the dollar will be killed soon. It must be so according to Bug religious beliefs. Well, not really. Gold and the dollar can move together for longer than we think if risk is the watchword. On growth, the dollar ultimately pulls ahead we think.
  3. Debt vigilantes who think rising government debt is directly correlated to the currency performance. We keep mentioning the performance of Japan i.e. soaring government debt and rising yen along with it. This is not to condone rising debt, but it is to say this situation can last for years.

So with plenty of long-term firepower still to come, rock on dollar bulls!


REPRINT from January 18, 2010

The Case for a Multi-year Bull Market it the US

The best place to start any currency forecast is of course with the US dollar. If we can get the dollar trend right, it significantly increases our chance of doing right—making money—no matter what currency we are trading. So, the key question we ask: Has the US dollar bottomed?

Our answer: The dollar has bottomed and has entered new multi-year bull market.
Since currencies began floating in 1971 i.e. governments no longer set currency prices and values were left to the forces of market supply and demand, there have been two multi-year bull markets, and the move from bottom to top has been significant.

#1: 1978-1995 (7-years) Approximate move = 100%
#2: 1992-2002 (10-years) Approximate rally = 55%

If we can catch a dollar multi-year bull move early, there is a lot of money to be made. Of course that requires we have the staying power—or confidence—to stay with the trade. Over the next several pages we are going to build a detailed case for a new long-term bull market in the US dollar. This kind of long-term trade setup doesn’t roll around very often. It is a great risk-reward trade. We know exactly where we are wrong; but the upside potential is huge.

We are going to take a look at the key fundamental rationales, historical precedence, and shape of the dollar move since it bottomed in March of 2008
Recently, in a Currency Currents issue, we laid out 10 Reasons Why the US#$ has Bottomed. Below are the ten reasons we gave. All still apply…

  1. Credit Crunch Sea Change
     US Savings going up; debt sentiment changed
  2. Risk Bid Trigger Again…initially
     Greece and Dubai
  3. Growth – Not as bad as expected; it’s all relative
     Non-farm payroll and Mr. US Consumer
  4. Carry trade idea history
     Fed hikes before BOJ and before ECB
  5. US Assets are very cheap
     Foreign Direct Investment Flow (currency cycles play that role)
  6. Sentiment – Newsletter writers are in apoplectic territory
     Everyone hates it and one-way bet
  7. Correlation – it has changed
     No new low with gold blow off and stock high
  8. Technical
     Broke its weekly down trend & extremely oversold
  9. Euro craters as a currency
     Rush to dollar-the world reserve currency punctuated
  10. Bill Gross isn’t always right; neither is Jim Rogers

…all are included in this story, embedded in the key thematic driver, five powerful reasons for a dollar bottom and beginning of a big multi-year rally.

As always, relative yield and growth are the two fundamental drivers of currencies. In addition, the world reserve currency is by nature well supported on risk. And if you add in the squeeze on Europe because of an overvalued euro, you have the recipe for a strong dollar. So, five major thematic drivers we see in 2010:

  1. Improving US current account deficit: This is the major global macro catalyst – a sign of a sea change in the global economy that will favor the dollar. I t is part and parcel to global rebalancing, as defined in #4 below. As the current account deficit in the US improves, it means US dollar supply is receding from the global economy.
  2. Improving Yield Differential: US interest rates, both short and long, will surprise to the upside in 2010
     This means the dollar will no longer be considered the carry trade currency. We expect to see a major improvement in yield differential expectations for the US, especially against European-block and Japan
  3. Foreign Direct Investment: US assets look cheap & risk will help the world reserve currency
     The long-term decline in the dollar makes US assets look cheap (classic role flexible currencies play in a normal cycle); this means we should see more foreign direct investment flow into the US.
  4. Risk: European Monetary Union turmoil and Chinese bubbles popping.
     Greece. Portugal, Spain, et al represents a risk event the will support the dollar in the first half of the year; and a major break in China growth and liquidity bubble in the second half thanks to China easy money and grinding impact of a global rebalancing* (US consumer is not buying as much and the emerging market world cannot take up the slack in global demand). The world reserve currency benefits when there is major global systemic risk. China is now the growth engine, trouble there will ripple across all asset markets. Major players globally will hide money in US Treasuries; they must buy dollars to buy Treasuries.
  5. *Global Rebalancing:
    Overconsumption <=> Overproduction
    Current Account Deficit Nations <=> CA Surplus Nations
    United States <=> China

  6. Valuation Squeeze: Relative undervaluation of the US dollar and Chinese yuan (because it is pegged to the dollar) and other Asian block currencies ex-Japan leaves the European block currencies taking the brunt of pain and stuck in the middle.
     The euro has been squeezed on both sides by relatively low values of the currencies of its major trading competitors: the US dollar undervaluation to its west and Chinese yuan undervaluation to its east. This means Europe must bear the brunt of this squeeze domestically. This comes a very precarious time for Europe—a major threat to its entire monetary system and core countries of Europe struggling under the weight of a currency on steroids. Thus, there are real fundamental reasons and major incentives for Europe (read the European Central Bank monetary policy) to allow the euro to decline—a lot.

As we gaze into our crystal ball, we see a very different first half of the year compared to the second. But for each half China is the key. It’s growth, or lack thereof, bookends the year we think. The European Monetary Union problems playing a supporting role:

1st Half Key Economic View:
Key Driver: China keeps the music playing in the form of easy money and liquidity flowing into the country; it continues to lead global growth.
 Commodity currencies perform relatively well on growth and yield (especially against euro, Swiss, and Japanese yen)
 US grows faster than Europe, UK, and Japan on export demand from emerging market countries; US growth rebound is trigger for higher rates, which in turn benefit the buck
 European Monetary Union continues to weigh on the euro; plus the European Central Bank and core countries stuck in Euro straight jacket are happy for currency relief
2nd Half:
 China’s music stops playing, bubbles begins to pop and growth disappoints—maybe 5% GDP growth instead of 8-10%
 Commodity currencies get hit hard
 Dollar gets a major risk boost; adding to already better yield background
 China bubble popping hits emerging markets globally leading to a sovereign default on one of the Eastern/Central Europe (Hungary, Latvia, Ukraine…); also pressures core euro member countries; all hits European banking hard.
Now a look at the US dollar index, where we are and where we’ve been for some clues as to where we go from here…

Now a look at the US dollar index, where we are and where we’ve been for some clues as to where we go from here…

Where we are now…

US Dollar Index Weekly: The US dollar index bottomed in March 2008. It proceeded to rally 27% before bumping up against the 38% retracement of its 2002 high to its 2008 low (see chart below).

But also notice how far the US dollar index has fallen since its rally up to the 90 level; it’s retraced much more than expected; falling to 74.21 in early December 08; this has emboldened the US dollar perma-bears who believe the rally we’ve seen in the buck is only a bounce in an ongoing bear market—the dollar ―must‖ go lower they say in order to make a dent in the US current account deficit (that’s another mistake we think they make).

The dollar and the US current account leads to our major reason the dollar has bottomed:

Dollar supply is falling around the globe. Falling supply and increased demand for dollars (there is still strong demand for dollar-based credit globally) means a higher dollar price if the laws of supply and demand still apply. [Some ask: How can dollar supply be falling when the US government is pumping out so many dollars? The answer is private deleveraging is still overwhelming government created credit that is sitting on the books of financial institutions.] Keep in mind, all else said about what drives currency prices, ultimately free-floating currencies that cannot be manipulated over any length of time by governments are driven by the market forces of supply and demand.

The US current account deficit is good depiction of the level of dollar credit going out into the world. An improvement in the current account reflects the fact that fewer dollars a being spread across…keep in mind Triffin’s Dilemma (US dollar replacing gold as reserve currency means the US is forced to run big current account deficits to provide liquidity to the global economy) as we talk about the current account in the context of dollar credit and it impact on the longer term price of the dollar—and on the key drive of global growth at the moment that benefits mightily from US dollar liquidity—China.

Déjà vu all over again
The bull market in the dollar that began in 2008 (we think) is looking an awful lot like the last bull market in the US dollar that began in 1992 and lasted 10 years. What’s interesting, it’s not only a similar technical picture and pattern, but the catalyst looks like it can be the same—and improving US current account deficit.

US Current Account Deficit: Notice the last two times we saw an improvement in the current account: bottomed in September 1987 (stock before market crash) and again in late 2006 (just before the credit crunch and major global conflagration). Is this a coincidence? We think not.

When the world reserve currency drains from the global system (evidenced by an improving current account), especially following years of easy credit and bubble building, bad things happen to asset markets.

  1. The improvement in the current account deficit in 1987 preceded:
    a. The 1987 stock market crash & Asian Financial Crisis
    b. The recession of 1990-91 [check these dates][Note: The world reserve currency historically outperforms in a recession; further validating the importance of the global supply of dollars through dollar-based credit.]
    c. 10-year bull market in the dollar and the 1990 recession.
  2. The improvement in the current account deficit in the 2006 preceded:
    d. The great credit crunch of 2008 & global conflagration
    e. The recession of 2008-10 f. The XX-year bull market in the US dollar? [This is our bet!]

What is also interesting is how the shape of last bull market in the dollar, 1992-2002, looks similar to the bottoming process in the dollar now. (Please refer to the next chart below)

The US dollar index put in a bottom in June 1992. It rallied about 25% from its Jun ’92 low to an intermediate-term high of 97.85 by September 1994 [the dollar rally from its low in Mar ’08 to its intermediate-term high of 89.71 represents a 27% rally].

From its intermediate-term high in September 1994, the US dollar index fell to a low of 80.14 in April 1995; that represents a retracement of 91% of the formal rally; this emboldened dollar bears who expected the bear market to continue; they were fooled. [Fast forward to today’s intermediate-term high in the US dollar index at 89.71 achieved in August of last year, it retraced 82% to a low of 74.21 in December 2009.]

US Dollar Index: Beginning of 10-year bull market 1992-2002

The price action in the 1992-2002 bull market and the current price action depicted in the current weekly view of the US dollar index on page 6 fit our typical boom bust price pattern, as shown below. It also gives us a roadmap of where we are in this multi-year dollar bull market; jus the beginning!