FT Alphaville today catches up to reality with an explanation of movements in the $US:
Take everything you ever thought you knew about foreign exchange and bin it.
According to HSBC’s stellar FX guru David Bloom, currency markets are trading through the looking glass, and will continue to do so for some while.
As he noted on Monday:
The FX market to some extent has been turned upside down and the concepts we used to assess the USD, and other currencies, have had to be put on the shelf. For some time we have suggested that the FX market has lost its anchor of reason and this still seems to be the case.
This is particularly the case for the US dollar. Bloom says that while the fundamentals used to give the US dollar primacy, the dollar is behaving increasingly like a residual currency. Though it’s nothing to do with fundamentals per se.
Simply, the world has changed and the dollar no longer has the primary position it once held.
And so it is that the US is able to reach its debt ceiling maximum with limited impact on the dollar, when in the old world this would hardly have been the case.
As Bloom notes, in the old world the debt ceiling chaos would have transpired something as follows:
In this world, the effects of the US either raising or not raising the debt ceiling are as follows. If the US raises the debt ceiling, an immediate crisis is averted, and this is USD positive. On the flip side, if the US does not raise the debt ceiling, there is major political fallout and the resulting scare stories undermine bond markets and the USD. This follows the line of thinking we have adopted for many years: the US and the USD are of primary importance.
But now, in a risk-on-risk-off (RORO) world, it goes like this:
We now set forth an alternative view of the world whereby the RORO phenomenon is dominant. So, EM currencies and risk assets are primary, and the USD is just the residual currency. To some degree, this is the world that we are currently in, and here we get very different conclusions.
This helps to explain the problems associated with analysing currencies at this juncture. Returning to the issue of the debt ceiling, when RORO dominates and we have the situation set out in diagram 6. Most people are much less comfortable with this argument than the “fundamentals” argument outlined above because it puts risk assets and EM as the primary driver and the USD is just a residual currency. In this case, when the US debt ceiling is raised, and an immediate crisis is averted, the market buys risk. This includes EM and as a consequence the residual effect is that the USD is sold. On the flip side, if the debt ceiling is not raised, this sparks a wave of risk selling and by default the USD rallies.
This is a world in which positive US news leads to a fall in the dollar, while negative US news leads to a US rally.
I’m sorry to inform the FT and its star, but good traders binned simplistic notions of US fundamentals driving $US strength a decade ago.
The dynamic of the $US weakening on good local growth has been operating with increasing strength since the dot com bust. It has been explained throughout by Doug Noland at Prudent Bear, who captured the mechanism in the metaphor of the “centre versus the periphery”. The centre is the Wall St securities complex which, when confident, breaths capital out to emerging market bond and equity markets, at the periphery. The irony is that Wall Street’s confidence is in some large measure determined by the state of its local economy. But in truth, so it should be, the same dynamic is reflected in trade flows in the real economy as good US growth boosts consumption and imports, thereby boosting risk market exports and growth, justifying the inflow of capital. Of course, those same economies tap into the cycle by recycling the forced savings of their mercantile policies into US Treasuries.
This is why, whenever someone complains to you about how world markets jump to Wall St’s tune, instead of say, Shanghai’s, you can dismiss them. So long as Wall St continues to mediate global savings through its securities complex and the $US, it will determine global capital allocations.
But Alphaville’s late to the party genius only captures half the story. The other half is the US Fed, which played a key role in developing the whole box and dice by underpricing US credit for decades. Loose money in the US has created a sequence of domestic credit bubbles that kept over-consumption going, even as production fled to other, cheaper markets. In so doing, it also created the vast US current account deficit that fundamentally drives the mechanism through booming developing (risk) economy export growth.
And these days, the whole system is overstretched because of debt saturation at home and overproduction abroad, which keeps US demand subdued, unemployment high and growth below trend. This, in turn, keeps the US Fed’s finger on the easing trigger. As soon as there is sufficient local weakness, reflected in falling securities prices (or vice versa), the market knows the Fed will ease monetary policy again and the $US falls once more. So, at some point, not too far away from now, US economic weakness will turn into $US weakness, when the market hears the distant cough of Bernanke’s helicopter starting up once more.
The whole damn mess is now a front running of the US Fed. Until global rebalancing happens, the dollar may be weak but it’s all the more powerful.
