ZT: Steven Jen on Currencies

Cyclical Dollar Correction in 1H; Story May Change in 2H

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A very benign global economic backdrop

Importantly, I continue to make the assumption that the prospective slowdown in the US and the global economy is a mid-cycle event, and not at all what some pessimists have in mind. My thesis, which I have proposed in the past, is that the world is far from having reaped all the benefits from globalization. The problem I have with the pessimists is that they may be focusing too much on the aggregate demand (AD) side of the equation and not enough on global aggregate supply (AS). To me, global AS will continue to grow at a rapid pace so as to keep the world in a ‘Goldilocks-like’ state for several more years. There could be differences in the growth trajectories of various countries, but the overall outlook for the global economy is very positive: the world will continue to be propelled more by AS than AD, in my view.

The single-biggest positive economic shock that the global economy has experienced in the past decade is the effective doubling of the global labor force. It has taken investors, commentators and policy makers several years to fully understand the implications of such a positive supply shock. However, I believe we are only half-way through the story.

The effective doubling of the global labor force has significantly depressed the global capital-to-labor (K/L) ratio, i.e., there are not enough ‘widgets’ for the size of the labor pool in the world. To re-establish global equilibrium of the K/L ratio, in the coming years, the world will need to embark on large capex spending. Most (not all) of the new capex should, theoretically, take place where the new labor is located, but in practice there are infrastructural and implementational constraints on large-scale capex in these countries

There is no economic theory that argues that the marriage of K and L needs to take place locally. Goods globalization is about accentuating the comparative advantages of countries. But to the extent that economic activities in the developed world (e.g., services) are increasingly less capital-intensive, the global economy could experience a period of low capex, high return on capital and low interest rates — exactly the curious combination we have witnessed in recent years. Until the world raises its capex, I believe that global interest rates will remain low and the convergence between equities and bonds will likely take place through an increase in the P/E ratio (an expansion in the multiples) rather than from a sharp sell-off in bonds.

The global economy has already registered five consecutive years of growth above 4.0%, making this the longest string of growth on record, despite continuous skepticism from many circles on the sustainability of the global/US economy. Based on the K/L framework, I believe that we will see several more years of strong global growth with low inflation.

Cyclical considerations for the dollar

As the US shows signs of weakness in H1, the USD could remain on the soft side against the EUR, but should weaken meaningfully against the AXJ currencies. This outlook is consistent with my ‘Dollar Smile’ framework. In a way, what the world gives up in terms of headline growth it will gain back through ‘better quality’ and more balanced growth — both geographically and sectorally.

By 2H, when the US economy is expected to regain composure, EUR/USD should sell off, while USD/AXJ could fall further, as risk capital accelerates toward Asia. The ‘de facto dollar zone’ is essentially a higher-beta alliance than the EU and the rest of the world, in my opinion.

Structural considerations for the dollar

There are four key structural considerations that I believe will distort the cyclical story for the dollar, and make it less ‘clean’ of a ‘dollar story’ for the currency markets. I list them in alphabetical order.

• Structural consideration 1. Carry trades. Cash yield differentials will likely remain important, though not dominant. As I acknowledged in my year-end piece, in retrospect, I did not respect the power of ‘carry trades’ (short JPY, short CHF) as much as I should have. Nominal cash yield differentials will likely remain an important factor for exchange rates through currency hedging and as a result of enhanced central bank transparency. Low volatility will accentuate the effects of nominal cash yield differentials. I stress that this is not the dominant factor, but an important factor to consider.

• Structural consideration 2. Diversification. Despite comments from some central banks, there is still no sign of wholesale diversification by central banks, based on the IMF’s COFER.

Having said this, I make the following points. First, while, according to the COFER data, neither the developing nor developed countries, as groups, have diversified, due to the fact that developing countries have, in the aggregate, a lower USD exposure than developed countries, and that the reserve holdings of the former have grown much faster than that of the latter, the world’s dollar exposure has declined steadily. In other words, even with no diversifying (reducing their USD holdings) by any country, the world’s dollar exposure could still continue to drift lower. The pace of the decline in the world’s reserve holdings in dollars in the last two years has been around 1% a year, with about two-thirds benefiting the EUR.

Second, investors need to broaden their frame of mind in thinking about currency diversification: this is no longer a dollar-versus-euros proposition. From a longer-term perspective, diversification will be two-dimensional (across currencies and across assets) and will involve substitution between the G3 currencies (USD, EUR and GBP) and the non-G3 currencies. Not only have the ‘sovereign wealth funds’ already gone that way, increasingly, the ‘excess’ official reserves will also be managed in the same way, in my view. In 2007, we are likely to see the beginning of this process.

• Structural consideration 3. ‘Global Funneling’. The rally in EUR/JPY has become one of the most powerful and out-of-consensus trends of the last two years. I proposed the ‘Global Funnelling’ idea to explain this trend, whereby financial globalization has tilted capital flows in favor of countries that offer developed financial markets. The fall in oil prices earlier this year lowered the C/A surpluses of the oil-exporting countries but boosted those of the Asian countries, leading to a muted net impact on total excess savings from these countries. ‘Global Funnelling’ will likely continue to exert an upward push on EUR/JPY and prevent it from collapsing.

• Structural consideration 4. Protectionism. As the US slows, with a Democratic Congress, I fear that the risk of protectionism has risen significantly. I believe there is a high probability that the 110th Congress will resort to protectionist measures against both China and Japan in 2007. This is one of the biggest risks to the dollar, in my view. To pre-empt this process, I suspect that Beijing will continue to guide USD/CNY lower, which in turn should drag all of USD/AXJ lower.

How these structural factors may matter for currencies

First, as I mentioned above, these structural factors will distort the cyclical story for the dollar. Second, unless protectionism becomes an acute issue, JPY could stay on the weak side, particularly against EUR and GBP. In fact, JPY is most sensitive to the interplay between these four structural factors, and therefore could be particularly volatile this year.

Bottom line

Against a benign global economic backdrop, the dollar is likely to continue to be primarily driven by cyclical factors this year. The USD should be most vulnerable in 1H, but should reassert itself in 2H, at least against the EUR. The key structural considerations are not valuation or the US C/A deficit, but (i) carry trades, (ii) diversification, (iii) Global Funneling and (iv) protectionism.