Betting on US Dollar as weapon of defence

Over the past few weeks the Euro/Dollar exchange rate has continued to move upward to exceed the 1.47 threshold for the first time since September ‘08. By contrast, better than expected US economic data during the summer was not enough to reverse the Greenback’s downtrend. Above-estimate news from the Euro area, with the German and French GDP improving by a surprising 0.3% q/q in Q2, cannot help explain the strength of the single currency. There is continued uncertainty surrounding the Eurozone economy, such as the poor health of some major economies including Italy and Spain. Moreover, the outcome of the new referendum on the Lisbon Treaty to be held in Ireland by November 2009 is another factor of uncertainty about the outlook of the European Union.

Two reasons appear to justify the Euro/Dollar uptrend. First, the short-term interest rate differential should continue to remain favourable to the Euro for several months, as both the Fed and the ECB are likely to leave interest rates unchanged for several months. In our opinion, there is still a long way to go before an exit strategy is implemented.

Second, the upward trend in the Euro/Dollar seems to be closely connected with the fall in the risk premium on international financial markets. Indeed the Dollar downtrend began last March, the month when the S&P500 saw its lowest since 1997. The negative correlation between the US Dollar and equity markets is due to the strong expansionary monetary policy pursued by the Fed: with the Fed Fund rate at 0% the US Dollar has become the new financing currency in carry trades, taking the Yen’s place. Several academic studies have shown that carry trades are profitable in the case of a downtrend in the market risk premium. The drop in the Vix below the 25.00 level, the narrowing of the spread between low-rated corporate bonds and US Government bonds and of the spread between emerging markets Government bonds and U.S. Government Bonds and limited volatility in the foreign exchange market are all symptoms of how the trend in market risk premiums is supportive for carry trades.

The U.S. Government might welcome a continuation of the carry trade aimed at weakening the dollar, provided that the move does not spark a strong reaction from the government of China, which sits on a mountain of dollars. A weak dollar, in fact, would have a great impact on the U.S. economy. First, it would boost exports and enhance American companies’ competitiveness. Second, as indicated by Hiromichi Shirakawa, a chief economist at Credit Suisse Tokyo, a weak dollar would increase the returns on U.S. investments abroad, increasing the wealth of businesses and households. Finally, a devaluation of the US Dollar would lessen deflationary pressures.

With the interest rate differential weighing on the US Dollar, carry trade operations using the dollar as the financing currency expected to continue due to the uptrend in market risk premiums and the U.S. Government that seems to view favourably the dollar’s devaluation, despite claims to the contrary, the current situation seems to favour a further appreciation in the Euro/Dollar in the short term.

Nevertheless, investors holding positions in the equity market should not bet on a further appreciation of the Euro/Dollar. Indeed, the strong correlation between the exchange rate and the equity market in recent months has given evidence that investing in the Euro/Dollar would not impact positively on a portfolio diversification. By contrast, building positions in favour of the US Dollar against the Euro could turn out to be a more viable solution.

First, the interest rates differential should not penalize the US Dollar as long as it did with the Yen, the carry trade financing currency ahead of the US Dollar. In fact U.S. interest rates (once clearer signs that the country has pulled itself out of the recession of the past two years emerge) will likely rise more quickly and achieve a higher level than those in the Euro area, although this scenario should not materialize before 2011.

Second, due to the recent upward move, the Euro/Dollar is overvalued by over 25% according to the Purchasing Power Parity (PPP) calculated by the OECD. 20% deviation from the fair value has historically been followed by a correction phase. As shown in the chart below constructed using the German Mark as a proxy for the Euro in the years ahead of its introduction, strong deviations from the fair value calculated by the PPP were followed by counter-trends to correct previous excesses. Therefore we are now looking for a Dollar revaluation in the medium term. This would not occur should inflation rise more markedly in the US than in the Euro area and therefore align the PPP with the Euro/Dollar’s present value.