2010-07-14

Fundamental reasons for a stronger U.S. dollar

Even though one factor may be enough to power a trend, I prefer investments that have several factors working in their favor.

In the case of the U.S. dollar, one argument is that there's a bull market based on the charts. Technical analysis is not concerned with the why.

The leading explanation for why the U.S. dollar will rally is that deflation will destroy U.S. dollars and make them more valuable (reduce the money supply through credit destruction). In addition to this "bearish" argument for a U.S. dollar bull market, there are also "bullish" arguments.

In a blog post today, Liu Junluo compares the U.S. economy's growth rate to the European economy's growth rate. He notes that when the U.S. was growing at 3-5% before 2008, Europe was growing at about 50-70% of the American rate. He sees the U.S. growing around 2.8% now, and Europe at 1%, or nearly one-third the rate. The difference is much larger and he believes it will translate into a major U.S. dollar bull market.
2008年前,美国经济年均增长在3%~5%,欧洲经济在2%~3%,那个时期美国经济增长速度高于欧洲经济50%~70%左右。现在美国经济最保守增长不低于2.8%,而欧洲经济最乐观增长是1%,从现在开始美国经济增长速度是高于欧洲经济是以几倍为基数来衡量了,所以美元未来疯涨又是个常识问题。社会不是由笨蛋来决定进步的,如果你相信美国核心层是由笨蛋组成的话,那何以解释中国大地愈演愈烈的移民潮。

Today, Michael Pettis discusses capital flows in The capital tsunami is a bigger threat than the nuclear option
In fact the real threat to the US economy is not the dumping of USG bonds. On the contrary, in the next two years the US markets are likely to be swamped by a tsunami of foreign capital, and this will have deleterious effects on the US trade deficit, debt levels, and employment. Investors and policymakers should be far more worried that China and other capital exporting countries are trying their hardest to maintain and even increase their capital exports, while the capital importing countries are either going to see capital imports collapse, or are trying desperately to bring them down.
Later on he writes
The US, in other words, is not likely to face the “nuclear option” of a Chinese disruption of the US Treasury bond market. It is far more likely to be swamped by a tsunami of foreign capital. This tsunami will bring with it a corresponding surge in the US trade deficit and, with it, a rise in US unemployment. It will also force the US Treasury to increase the fiscal deficit as more of the jobs created by its spending leak abroad.

Therein lies the problem. A reduction in net foreign capital inflows means a welcome decline in the US trade deficit, but the US is likely to see just the opposite. Foreign capital will push desperately into US markets and as an automatic consequence the US trade deficit will surge. So the problem isn’t too little capital inflow or a sudden boycott of USG bonds. On the contrary, the US will see too much capital inflow.

All this may turn out to be very bad for the US economy, but in the past massive capital recycling has usually been very good for asset markets. Might we see a surge in the US asset markets, at least until next year when Congress starts getting tough on the trade deficit? I would be willing to bet that we do.
I suggest reading the whole post if you are interested in speculation about Chinese dumping U.S. treasuries and why that won't happen.

As for a bull market in U.S. assets, I'm not fully convinced that U.S. markets will go up, but I do expect they will be relative outperformers because We are all currency traders now. In this article, Howard Simons concludes:
US mutual fund investors have been pumping their hard-printed pieces of paper overseas more than they've been keeping them home for the past five years, with the prominent exception of late 2008. This behavior has held regardless of the trend in the dollar, which indicates a belief that greater returns are to be had elsewhere. The sad truth is global equities have been homogenized by an efficient market into the current price reflecting future expectations for earnings. All that's left, then, is a currency trade -- and an expensive one at that.
Not far off from Prechter's "All one market" argument.

For the U.S. dollar bulls, there's a little comfort in knowing that the asset bulls and bears both find compelling reasons for a U.S. dollar rally.

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