Friday, 10 December 2004

Going contrarian on the US dollar

In his Bloomberg column, Mark Gilbert warns about selling the US dollar.

Questions to Ask Before You Sell That Next Dollar
The dollar is about as popular as a broken toy on Christmas morning. It seems to set fresh lows against the euro on a daily basis, while the threat of renewed yen sales by Japan hasn't arrested its slump. The Bush administration may welcome dollar weakness as a balm for its trade and current-account deficits. The European and Japanese administrations have failed to talk the U.S. currency higher. In the past week, the dollar reached 101.83 yen, its weakest since January 2000, and a record $1.3470 per euro.

Before you jump on that bandwagon, here are some key questions, all of which address the same basic point: Do you really want to own euros and yen?... Investment banks are elbowing each other out of the way in a race to post the lowest dollar forecast. Whenever "everyone knows" about a one-way bet, it's often time to consider becoming a contrarian. One of the strange axioms of financial markets is that everyone agrees there's no such thing as a free lunch, until they think they spy a plateful of gratis set in front of them. Do you really think betting against the dollar is a free lunch?...

The Fed funds rate, currently 2 percent, is heading north. By contrast, the Bank of Japan's 0.15 percent benchmark rate and the European Central Bank's 2 percent lending rate are headed east at best; the ECB may even cut rates by half a point next year, according to economists at Goldman Sachs Group Inc...

"Buy low, sell high" is a pretty good trading tactic. "Own the currencies of countries with strong economies" has also proven to be an efficient strategy over the years. Are you sure you want to contradict this maxim?... The U.S. economy grew 3.9 percent in the third quarter, outpacing the 0.3 percent rate for the 12 nations that share the euro, and the 0.2 percent growth rate achieved by Japan. The OECD is predicting U.S. growth of 3.3 percent in 2005, compared with 1.9 percent for the euro region and 2.1 percent in Japan.

Do you really want to own euros and yen?

In the first part of his article, Gilbert suggests a possible contrarian play. That's an interesting thought, to which I'll come back later.

But the second part, which suggests that the stronger economy in the US should be reflected in the currency, is something which I have dealt with before. As I have said previously -- most recently in "End in sight for fall in US dollar?" -- a stronger economy does not necessarily correlate with a stronger currency, especially when the economy is driven by consumption and deficit instead of investment and surplus. If anything, the reverse may be the case.

Having said that, the US dollar has indeed been reversing some of its losses over the past few days. The reason, according to dealers, is "technically-driven position-adjustment" (see "US dollar extends rebound in Tokyo early afternoon trade"). The longer-term trend, though, remains down. In other words, the US currency has fallen too fast, but not necessarily too far, especially against the Asian currencies.

And the latter, ultimately, may be the undoing of Gilbert's theory regarding going contrarian. While private foreign exchange traders may be short on the dollar, Asian central banks are still effectively long on the currency. And with their large holdings of US dollar assets, the Asian central banks' position may better represent the "consensus" than the private traders.

In which case going long on the US dollar can hardly be said to be contrarian.

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