Returning to the Scene of an Accident

The market overreacted to the recent U.S. jobs report and while expectations of Fed policy have returned to status quo ante, the dollar has not. We suspect the dollar is therefore vulnerable to a renewed near-term setback. The yen is obviously exceptional and the dollar has already surrendered its job-induced gains. We would also discount sterling on grounds that fiscal developments in the UK leave it particularly vulnerable.

Concerns about growing debt burden are likely to dominate discussions. While tax on bank bonus payments is not playing particularly well in the blogsphere and the op-ed pages, early indications suggest it is aiding Labour in the polls. This in turn increases the likelihood that Labour becomes more populist in the coming months and risks a hung parliament.

That leaves the euro and Swiss franc. The former seems to be a cleaner expression of the view, but the high correlation between the two makes it really the same play.

Turning to the euro then first, we expected the break of $1.4800 to spark a move toward $1.4600. The low from early November came in near $1.4625. The euro dipped below $1.4670 briefly near midweek and has bounced back a cent. To be sure most technical indicators, like RSI, MACDs, and Stochastics, have not turned.

Nevertheless, the preliminary signs of a potential turn may be at hand. The euro has not closed above its 5-day moving average since December 3rd. It comes in today near $1.4750. Ideally, a weekly close above $1.4780 and a move above $1.4850 next week would signal a return to the $1.50.

The divergence of credit quality in the euro zone, underscored by rating and outlook adjustments in recent days, seems to have run its course in the way that it ebbs and flows. Peripheral bond markets such as Greece, Portugal, Ireland, and Spain are finished the week on firmer footing. The EU wagons are circling around Greece more favorable news is likely in the next news cycle that features the unveiling of more detailed fiscal reforms next week, though appear to be being leaked or floated currently.

The dollar has not traded below CHF1.0 since the jobs report, recording its highs since that data just yesterday when it briefly poked through the CHF1.0300 level. That is the strongest the dollar has been against the Swiss franc since November 3rd.

The euro has risen through yesterday's high, but it has not been confirmed by the Swiss franc, which has thus far remained above CHF1.0238 against the dollar. A break of this area, and ideally a weekly close today below CHF1.02, may signal a retest on par and/or boost confidence of the near-term dollar bearish case.

Medium Term: Dollar Constructive

This dollar bearish view for the near term should not obscure the face that we retain a more constructive view on a medium term basis. We continue to attribute much of the dollar’s decline to the cyclical influences of the low U.S. rates in absolute and relative terms, and the major countries are still committed to reflation and underwriting risk to a significant extent.

A year ago, officials were worried about an implosion of liquidity and they responded decisively. And in so doing, encouraged the return to the scene of the accident—the dollar’s use as a funding currency. In fact, this is one dimension of market normalization: the smooth funding of dollar assets. It also encourages the dollar-carry trades.

The dramatic shortage of dollars that was evident last year was responded to aggressively by the Federal Reserve through swap lines with foreign central banks that at their peak were worth more than half a trillion dollars.

The next big shift in policy will be in removing the extraordinary liquidity and monetary stimulus. We expect U.S. interest rates to rise relative to the euro zone, the UK, Switzerland, and Japan. However in 2010 this is likely to be more of a second half story than and a first quarter story.

The structural arguments for the dollar’s weakness, like the diversification of central bank reserves and the increased use of the yuan for trade purposes, appear exaggerated. For example, after many years of claiming diversification of reserves, hard evidence is sorely lacking. Many observers think that there was finally some evidence in the second quarter 2009 IMF data. However, the fluctuations appear fairly normal. For many countries, valuation adjustments appear more important than new flows. In any event, third quarter COFER data is expected at the end of December.

What about the Yuan?

Most arguments about the yuan eclipsing the dollar are of a medium and long-term nature. They are in the realm of notoriously unreliable speculation, largely based on linear projections of recent data. Today the yuan is not convertible. The Chinese debt markets are neither deep enough nor sufficiently transparent for many reserve managers.

As the limited international role of the yen demonstrates, size of a country’s GDP is not necessarily a good predictor of its reserve status or use as an invoicing currency. The yuan swap lines that the China has established with a handful of other countries are less than 80% of exports in a single month. China’s November exports were valued at $113.6 billion while the swaps lines are valued at about $90 billion.

Japan’s Nikkei peaked 20 years ago this month. Some Chinese officials believe that these lost decades in Japan are partly a result of its capitulation to U.S. pressure for a stronger yen. Many also understand late 1990s crisis in Russia and East Asia as a function of their too rapid embrace of more open capital markets.

No doubt China will make other mistakes, but seeks to avoid these. That suggests China’s ascendancy, if it is that, is more gradual that would be suggested by the perma bearish dollar views that are often heard.

In turn, this means that the dollar’s role in the world economy is unlikely to be eclipsed in the time horizon of most investors and allows our attention to remain on more immediate cyclical factors.