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Can Greenback Come Back?


Debating dollar's trajectory.

You have read it in the papers and you have experienced it while planning your travels: the US dollar has fallen to a record low. Like Hillary Clinton's quest to become President, the question on everybody's mind is whether the dollar will be the comeback kid. It shouldn't be a surprise to anyone that the US cares only about the US. The US wants to lower interest rates and wants the US dollar to be weak, regardless of the consequences that it may have on its trading partners. Let the Europeans complain, let the Japanese complain, the dollar will continue to fall. Or will it?

What's Driving the US Dollar Lower?

Oh why, oh why, oh why... is the US dollar getting killed? Yesterday, the dollar hit a new all time record low against the Euro as fear and gloom sets across both Wall Street and Main Street. Activity in the service and manufacturing sectors are contracting, leading everyone to believe that not only will we see another month of job losses, but we will also see a contraction in retail sales. Yes, gas receipts and food prices are rising which could increase the absolute value of purchases, but this does not take away from the fact that this trend hurts - not helps - the US economy. Earlier this week, Warren Buffett proclaimed that the US economy is already in a recession. I think that recession or no recession is just a matter of semantics at this point. The Federal Reserve seems to agree, which is why last week Fed President Ben Bernanke basically told the markets that it will be putting 100% of its focus on growth. According to Fed fund futures, the choice for the Fed at this month's monetary policy meeting is between cutting interest rates by 50 or 75bp.

Will it Continue to Fall?

Yes. There is a decent chance at this point that we may see 1.50 to 1.00 percent interest rates. The Federal Reserve is behind the curve. Two year bonds are yielding 1.678 percent while Fed Fund rates are 3.00 percent. That's a difference of over 130bp. Since 1990, the average spread between the 2-year treasury rates and Fed funds is approximately +50bp and over the past 10 years, it is +25bp. Therefore it's not rocket science to see that a gap of -130bp is a huge discrepancy. In order for the gap to be neutral, the Fed would need to immediately cut interest rates by 125bp. In order for it to revert back to the 10 year average, rates would need to come down 150bp, putting the Fed Funds rate at 1.50 percent. This is why I think interest rates will continue to fall and the US dollar will come down with it. BUT with that in mind, I still think that the US dollar will recover in the second half of the year.

OK, so let's see. You believe that rates will fall to 1% but still think the dollar will bounce back. Why? What on earth makes you think that we'll see a recovery as the year progresses? We all know the facts: $1 trillion dollars of housing wealth evaporated. it now takes $7 of debt to generate just $1 additional dollar of GDP. And on top of that we are stuck with another trillion dollar boondoggle in Iraq. As a wise man once said, a trillion here and a trillion there and pretty soon you are talking about real money. If anything, I think the economy will become much worse not better in second half of the year.

It's all about expectations. As you can see, the Treasury market is already pricing in lower interest rates. Don't forget that the dollar began to fall before the Fed cut interest rates and it will rise before it actually raises them.


I'm looking at 1.55 in the EUR/USD and 100 in USD/JPY. Admittedly, these are psychological levels, but as US rates continue to come down, these levels are completely reasonable. In fact, I even think that the exchange rates could overshoot those levels. However anything beyond that I think will require another big surprise – prompting those 2 year bond yields to fall even further.

Yes 1.55 and 100 are certainly reasonable, but why stop there? We all know that markets always go to extremes. It's the nature of the beast. Human beings never practice moderation, no matter how many times Socrates tells us to do so. So why not 1.65 on EUR/USD and 80 on USDJPY? Ridiculous? That's exactly my point. When cab drivers start refusing dollar bills and ask for euros – that will be the end of the dollar decline.

V Shaped Recovery?

I am a strong believer that we will see a V or at least a U shaped recovery in the US economy that will trigger a dollar recovery and rally in the second half of the year. The Fed's doing a lot right now and it's being extremely aggressive and this would be especially true if it cuts interest rates by another 50 to 75bp this month. Imagine the relief for US consumers and businesses if interest rates came back down towards 1.00 percent. Everyone will be rushing to lock in those rates and use that money for refinancing or capital expenditures. The degree of monetary and fiscal stimulus in the pipeline should lead to a shallow downturn and a swift recovery. Unlike the past, there is still a lot of money to be spent in the Middle East and Asia. When the US recovers, investors in these countries may sweep in with newfound optimism, which will give the dollar a chance to recover as well.

Investors can buy all they want right now and they are not exactly rushing. After all the DJIA is only 7970 in euros and yet it is down as I write this. Note that officials from Dubai said earlier today that they weren't sure they will invest more into Citigroup (C). That's a sign that the world may no longer view US brands as leaders in the market. It's the 21st century and everyone else has caught up and even by passed us on the information highway. So selling the US' old goods may not work this time.

As to low rates, well I've got one word for you: J-A-P-A-N. Just because you make debt low cost doesn't mean anyone will want to borrow. Not when they are sitting on a pile of debt the size of the Empire State building and paying rates to the credit cards that would make the Gambino family blush.

And just to rub more salt into the wound, any money the consumer has left is going into buying gasoline and milk. According to a recent story in NY Times, Charles Biderman, the founder and chief executive of TrimTabs Investment Research, a proprietary research firm in Santa Rosa, Calif. says "The big picture is: the amount of money people have to spend, which includes money on real estate transactions, is plummeting, and it started to break down in October."

What will take us out of this mess? Technology as usual. We've always innovated our way out of trouble. But until some kid in some garage somewhere creates a hydrogen engine that we can use for pennies on a dollar, I am a bear. This was one big bash of a party and I am afraid the hangover will last a long time

Where are the Currency Plays?

I've given my targets. I still like long EUR/USD, short USD/JPY and shorting CAD/JPY. The Bank of Canada cut interest rates by 50bp this week which was a big surprise for the market. It said that there is more to come which is why I am particularly bearish the Canadian dollar against the Japanese Yen. In fact, I am bearish carry trades in general.

No argument from me, especially on the yen and also the Swiss franc and if the slowdown hits the rest of the world – watch out! The Aussie and the Kiwi will fall 2000 points in a month.

What Does this Mean for My Stock Positions?

Before the dollar manages to recover, more damage will be done. Japanese corporates are particularly hard hit and I think Canadian and European companies will be as well. The Nikkei is already down 15 percent since January as Japanese companies are hit by the triple whammy of weaker sales, higher material costs and quickly appreciating currency. According to the Tankan report, we are well below the breakeven point for Japanese corporations. Toyota Motor Corp. (TM) for example said that the weak dollar cut fourth quarter profit by $194 million USD. Yamaha Motor Co. also said that it expects net profit to drop by 17 percent this year because of USD/JPY weakness. Expect more pain to be felt, which means bigger losses for all major foreign exporters.

I think the best short is the US retailers RTH. The pain hasn't even started to hit and when it does I think the index falls 50% from these levels. I know that Christmas is far away, but I think Grinch already stole it.
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