Four Fall-Lines for the Dominos
March 17, 2008
By Stephen Jen | London
Summary and Conclusions
Recent data suggest that the US real economy is indeed slowing and its financial markets remain under severe strain. However, the macroeconomic data for much of the rest of the world (RoW) continue to surprise on the upside. In this note, we argue that, if the US does indeed fall into a recession, there will be repercussions for the RoW and their currencies. But this domino effect could follow four – not mutually exclusive – fall-lines. First, in times of broad risk aversion, we could see the currencies of current account (C/A) deficit countries weaken. Second, as the ‘Anglo cycle’ of debt and housing falters, the economies with financial systems and debt cycles similar to those of the US may suffer in turn. Third, if indeed the global economy is infected by the weakening US, commodity prices may put in a top, and commodity currencies may suffer. Fourth, perhaps the most obvious fall-line is how a slowing US economy could affect the RoW through trade. We stress at the outset that this note lays out some conceptual issues for investors to consider. There is frankly too much uncertainty for us to predict, at this point, which of the four fall-lines will occur first or will be the dominant one of the four. Our hope is that this note will provide some preliminary food for thought for investors in anticipating how the chips may fall in the period ahead. The Dominos Will Fall We do not have any intention of raising the debate of economic de-coupling in this note. Our position should be familiar to regular readers of our work: while the impact of a slowing US economy will no doubt, with a delay, be felt by the RoW, the magnitude of the shock may be more modest this time around, compared to the previous episodes. But the deepening and the broadening of the financial crisis in the world, along with the negative shock to the real economies of the world through trade, should ultimately have implications for currencies. At this point, when the US is the only economy in the world that is slowing, and the Fed is the only central bank that is cutting aggressively, and with risk aversion no longer at its extremes, the dollar has weakened, as the ‘Dollar Smile’ has not been powerful enough to fully compensate for the yield deficit of the US. In the coming months, however, the trends in the currency markets may be quite different, as the ‘dominos’ start to fall. There are four main fall-lines we see. They are not mutually exclusive: - Fall-line 1. C/A deficits. As the global financial markets tighten up and liquidity becomes more scarce, on a global basis, the currencies of the economies with large C/A deficits could be more vulnerable. The TRL, Baltic currencies, NZD, ZAR and even the AUD could be more vulnerable than other currencies as global risk-taking retrenches further.
- Fall-line 2. Anglo financial structure. Countries such as the UK, Australia, New Zealand, Spain, Ireland and India that have the ‘Anglo financial structure’, i.e., the Anglo financial system as well as high leverage and high exposure to frothy housing markets, may also be more vulnerable than other countries. The remarkable feature about the US is that there was no obvious trigger for the housing price correction: housing prices began to fall because of gravity. This raises the question why the same process could not take place in these other economies.
- Fall-line 3. Commodities. Commodity prices are at extreme levels. This is remarkable not just because of the high absolute prices but also the fact that the global economy is decelerating. If indeed the global economy slows meaningfully because of a weak US, then there will be downside risks to commodities and commodity currencies.
- Fall-line 4. External trade. We will not elaborate on this particular channel, as it should be familiar to most readers.
In short, we propose four not mutually exclusive fall-lines for the dominos. Why Germany and Japan Seem So Resilient In thinking about the order of the dominos, investors and analysts may have the habit of going from large economies (the US and Euroland) to smaller ones (Korea and Turkey). But this may not be appropriate. In previous work we’ve done, we pointed out that Germany and Japan are not just large exporters, but are specialists in capital goods exports. Further, for Germany, exports to Asia now account for around 30% of non-EMU exports – exceeding the 25% or so heading to the US. Similarly, for Japan, some 50% of total exports go to Asia, compared to 17% heading to the US. This latter figure, in fact, has declined from 33% as recently as 2002. Thus, as long as capital goods imports – mostly driven by investment – remain strong in Asia and other emerging economies (or ‘Second World’ countries), Germany and Japan could continue to exhibit greater resilience to a US slowdown than historical patterns suggest. Thus, for Euroland to recouple with the US, we may need to see the Mediterranean economies weaken further to alter the view of the ECB. For Japan, we will need to see China and the rest of Asia slow, and for domestic demand to slow, before we see a meaningful deceleration in headline GDP. In any case, my colleagues in Europe and Japan have the view that both economies will slow materially this year. We merely provide one hypothesis to help explain why it may take a bit longer for these two economies to re-couple with the US. Bottom Line We try to consider how the ‘dominos’ could fall in the months ahead, as the US slows. While there are too many uncertainties for us to be committed to one particular scenario, we propose four possible fall-lines for the dominos. These possible paths are not mutually exclusive.
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Still on Intervention Watch, but Time Not Yet Ripe
March 17, 2008
By Stephen Jen | London
Summary and Conclusions A hyper-proactive Fed, coupled with economic data supportive of the economic de-coupling thesis, has contributed to the relentless decline in the dollar. We believe that the dollar will remain vulnerable in the coming weeks, at least until there are more convincing signs of economic re-coupling in the world outside the US. However, in this transition period, the decline in the dollar, in our view, is starting to fuel vicious circles which, in turn, are negative for the dollar. We believe that the probability of coordinated interventions (CI) is rising, though the risk of such an event is not imminent, as some key prerequisites are not yet met. The recommended tactical posture is to remain short the dollar. Nevertheless, we remain on intervention watch, tracking whether the preconditions for CIs are met. A Brief Background on CI We last raised this issue in Waiting for Coordinated Intervention? (November 1, 2007) when EUR/USD was 1.45 – 10 big figures lower than today’s spot rate. We argued that the toxic mix of cyclical and structural ills plaguing the dollar could degenerate into large-scale capital flows and diversification out of the dollar; CI may eventually be needed, we argued. We suspected that the dollar’s descent may not stop or reverse unless it was stopped, or unless the G7 conveyed a clear policy message. History shows that, as a rule rather than an exception, multilateral CIs have been key in establishing turning points in multi-year trends in the major currencies in the past three decades. This does not suggest that multilateral CIs are all-powerful. Rather that, done in the right circumstances, these ‘definitive policy gestures’ may have been effective in encouraging investors to react in a way that has helped the currency markets re-equilibrate themselves. The sole exception was 2002, when the dollar’s ascent began to abate, unprovoked by official action. Given that the dollar is at a multi-year low against many currencies in the world, it is prudent to be on a CI watch. The Case for Multilateral CI Now There are primarily two vicious circles which the weakening dollar is fueling: • Vicious circle 1. A weakening dollar feeds through commodity prices. There is a close correlation between EUR/USD and oil prices in the past year. A good part of this correlation is the direct ‘numeraire effect’. Specifically, of the increase in oil prices since 2002, about 30% can be explained by the movements in the dollar. In addition, there are indirect effects through financial portfolios, as large institutional investors, such as pension funds, hedge funds and SWFs, deploy a greater portion of their portfolios to commodities – precious metals, base metals and energy. This has exaggerated the relationship between the dollar and oil and commodity prices, even though genuine supply and demand also played a meaningful role. Thus, there is a vicious circle between (i) the falling dollar, (ii) rising commodity prices, (iii) the impression that inflation is high and rising in the world, (iv) the world having to remain vigilant on inflation by keeping interest rates high and currencies strong, and (v) the dollar falling as a result of this and a hyper-proactive Fed. High perceived global energy and food inflation – both of which are affected by the value of the dollar – also undermine the credibility of the Fed (i.e., backing up the notion that the US faces an acute form of stagflation), further hurting the dollar. • Vicious circle 2. A weakening dollar, at these extreme levels, is starting to inflict serious damage to investor confidence in USD assets. The excessive weakness of the dollar is starting to hurt the global equity markets and, more importantly, it is accelerating the quiet erosion of investor confidence in the dollar and dollar assets. Investors who have previously been constructive on the USD over the medium term are starting to lose confidence in the dollar. If one or some of the GCC (Gulf Cooperation Council) pegs break, which we believe is a distinct possibility this year, a negative feedback loop between the USD and USD assets could be accentuated. Embedded in this discussion are the trade-offs between the costs and benefits of this ‘we-are- devaluing-our-way-into-prosperity’ currency policy that the US is perceived to have. While a super-weak dollar is, after six years of decline, finally starting to be accompanied by favourable export performance, there are serious side-effects for the asset markets. Further, the apparent policy of ‘benign neglect’ adopted by the US Treasury has undermined its credibility, in our view, as the ‘strong dollar mantra’ no longer appears to be taken seriously by investors. Arguably, the ECB has taken a bigger leadership role, through its verbal interventions lately, than the US Treasury has on the dollar. If the US Treasury truly believes in the benefits of a strong dollar, we believe that this may be a good time to show more leadership before it suffers possible structural damage to its own credibility on the dollar. It is likely to be clear to most that EUR/USD is grossly over-valued. But investors would not act to buy the dollar unless the G7 ‘puts its money where its mouth is’. This is partly why, in the past, joint interventions were so effective: the powerful signaling effect, with the tailwind of valuation, has in the past allowed private sector capital flows to follow CIs. Why the G7 May Be Hesitant to Engage the Market Just because the level of the dollar is at extremes against many currencies, does not automatically imply that the G7 will intervene. There are several concerns that the G7 may have in mind. We list the key ones below: 1. Divergent monetary paths. This point should be familiar: the ECB will not intervene to cap the EUR unless its monetary path stops diverging from that of the Fed. This may not mean that we need to wait until the ECB has an easing bias but, at a minimum, it needs to have a neutral bias. 2. Waiting for the world to re-couple with the US. The economic de-coupling-re-coupling debate is not a binary one. We are of the view that the rest of the world (RoW) is less coupled with the US than in the past, but it will feel the impact of the US slowdown. The issue is the time lag. Historically, Euroland’s business cycle lags that of the US by a quarter or two. Thus, even if the world is as coupled as before, we will still have to wait several weeks before seeing definitive signs of a slowdown in Euroland. This matter is, of course, related to the point above about divergent monetary policies. It is also, presumably, a concern for the US Treasury regarding CIs, as it may not want to intervene in the currency markets if the world remains de-coupled. 3. The ‘market-is-always-right’ philosophy. This is an economic philosophy strongly held by the current US administration. However, the view that ‘the market is always right’ or that ‘the market will always do the right thing’ is contentious. There have, in history, clearly been moments of breakdowns in the market, leading to negative spirals with negative sentiment feeding on illiquidity. The vicious circles don’t need to normalise, in an environment of multiple equilibria. The same argument applies to the dollar. The US Treasury has been, in recent years, preaching to the RoW on the power of the market to make the right decisions, and that interventions are bad. This philosophy is being stress-tested now. Despite arguing years ago that the Treasury should watch for signs that sovereign bonds may be undermined by the dollar, i.e., bond yields start to rise, reflecting investors losing interest in the ultimate safe-haven asset, we think that the situation is very different now. Just from general risk aversion, we are seeing large purchases of Treasuries by USD-based investors themselves. In thinking about the dollar, the US Treasury can no longer just look at the yield curve, as if and when US yields start to rise because of the dollar, it would already be too late. 4. Diversification by other central banks. The world has changed since the last rounds of CIs (Plaza in 1985, Louvre in 1987, JPY in 1995 and EUR in 2000), in that the ‘second world’ economies and central banks are much more important. For CIs to be successful, we think the endorsement from China and Saudi Arabia will be important. What We Believe Will Most Likely Happen We believe that it may now take CIs to halt the slide in the dollar, but the aforementioned preconditions will need to be met before the G7+2 will take action. Bottom Line Our recommended tactical posture is to remain short the dollar for the time being, despite it being grossly undervalued against the majors. The preconditions for coordinated interventions are not yet met. However, given that a weakening dollar is fueling dangerous vicious circles through commodity prices and eroding confidence, it is prudent to remain on an intervention watch, monitoring closely whether the preconditions for interventions are met.
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BRRRL: Measures to Chill a Hot Currency?
March 17, 2008
By Marcelo Carvalho | Brazil
The Brazilian authorities have this week announced measures to contain BRL appreciation. While such measures seek to temper near-term pressures for further BRL strengthening, we suspect that they will ultimately prove counterproductive, as fundamentals should prevail over time. The context. The local press has reported that the recent measures are aimed at containing BRL appreciation, supporting exporters and slowing the rapid deterioration in Brazil’s external accounts, as imports are currently growing much faster than exports. According to the reports, advisors to the president have warned him that the presidential elections in 2010 could take place amid a widening current account deficit, potentially reintroducing concerns about external vulnerabilities. Three measures were announced this week: i) A one-way, upfront IOF tax of 1.5% on foreign investments in local bonds; ii) Exporters will now be able to keep all their dollar proceeds abroad if they so choose; and iii) Exporters will no longer need to pay IOF tax of 0.38% on FX transactions (undoing a measure announced in January 2008). Our View 1) The trade balance surplus is indeed shrinking fast. Our long-standing, out-of-consensus forecast had Brazil’s trade and current account balance worsening more rapidly. The consensus view has steadily moved our way in recent months, and there is further to go, in our view. It seems that recent actual external account data have now deteriorated enough to spark concerns among the authorities themselves. 2) How to respond? The freer the FX market, the better, in our view. In our opinion, the sooner that Brazil lets its currency more freely find its level, the better. Measures ii) and iii) are welcome developments, but do not greatly alter the picture facing exporters. Measure i) is the key one. But its ability to curb dollar inflows is questionable: Do not underestimate the market’s ability to bypass the rule with creative derivatives structures. To the extent that the measure does have an impact, it will tend to hurt the long end of the local yield curve, where foreign investors tend to focus. In a sense, thus, it is a shot in the foot of the Treasury’s effort in recent years to extend and develop the long end of the local curve with foreign participation. Introducing restrictions on foreign investment into local markets risks being seen as an unwelcome step back, in our view. 3) Uncertainty premium? Another undesired side-effect – investors may well demand an uncertainty premium as the rules of the game change. The authorities have said that the ultimate goal is to support exporters. They add that the recent measures are just the beginning, and that there is more to come. This is likely to include more tax breaks for exporters, So far, the authorities stopped short of re-introducing the 15% income tax on fixed income capital gains (which they had removed for foreign investors in early 2006). This would require congressional approval. But can we really rule it out for the future? Most investors would likely view sudden changes in the rules of the game as working against – not in favor of – bringing Brazil closer to investment grade status. In the end, fundamentals tend to prevail, and measures to alter the currency path appear to be of questionable efficiency over the long term. 4) There is a policy dilemma. The latest developments serve as a timely reminder of a policy dilemma facing the authorities in Brazil. On the one hand, the central bank has espoused hawkish rhetoric, indicating that inflation concerns could trigger eventual monetary tightening. But on the other hand, high local interest rates tend to attract capital inflows. Steady central bank intervention to buy dollars in the spot market, and all the talk about potential measures to curb BRL appreciation, suggest discomfort within parts of the administration about the undesired side-effects of BRL strength for exporters and for the trade accounts. Bottom Line The ability of recent measures to curb BRL appreciation looks questionable to us. But they could hurt policy credibility if they introduce uncertainty about the rules of the game. The measures thus risk proving ineffective at best, harmful at worst.
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