Monday, December 29, 2008

Themes for 2009 - Part 3 (Currency Outlook)

The recent volatility in currency ratios has made life difficult for even risk-averse investors who have fled to the relative safety of cash. Those holding the wrong currency have also been punished, although not as badly as equity or commodity investors. For example, Japanese investors who have been holding British Pounds, Korean Won or Australian Dollars are down ~40%. At times they have been down even more. People who thought they could garner a few extra points on their savings accounts by putting it all in Iceland are now finding out the hard way why those banks were offering higher rates.

I mention this to illustrate an important point: A currency only holds value relative to that of another currency or asset.

That's not exactly a page turner, but for those incessantly screaming about the coming demise of the US Dollar, it should be. This is something I have been harping on for years now. The US Dollar Index is only a measurement of other currencies, primarily Euros, Yen, Pounds and Loonies. Most of the arguments made from the "Dollar Doom" crowd (think Peter Schiff, Jim Rogers, Doug Casey, etc - all of whom I respect very much) are along the lines of "too much debt," "fiat currencies always fail," "poor economic management," or something of the like. None of those statements are false. However, they are correct for all of the major currencies. Therefore, expecting the US Dollar to go down simply because the US is in too much debt is not a rational argument unless it's competition is actually saving. They're not. It is a global race to the bottom.

The above logic was the rationale for one of my 2008 themes: "There will be a time for both large declines and large gains for the US Dollar - likely in that order." I thought that the expectation for the credit crisis to be contained to middle-class America was absurd. And once the realization hit that the problem was global, a major rally would occur in the US Dollar. Indeed it did:

click image to enlarge

I view the recent reversal as a technical correction of a larger bull move for the USD. My outlook is that it will continue to strengthen throughout the course of '09. Again, the primary reason for my views on the US Dollar have very little to do with the US. It is my extreme pessimism on the Euro and British Pound that I see as the potential catalysts for this action. In my opinion, the EMU (European Monetary Union) is not stable. What was workable during a boom economy during the last 10 years or so is not necessarily workable during the bust. Protectionism and busts are nearly synonymous. Already we're starting to see signs of infighting among the member nations. For years, the southern countries (Greece, Italy, Spain and Portugal) have been very opportunistic in the running of their finances. Whereas the northern countries (especially Germany) have been very careful. Now as the entire Eurozone plunges into recession, the fingers are starting to be pointed. I don't see how the northern countries can avoid the urge to blame someone else for their economic problems. The logical evolution for those sentiments are to favour going back to their pre-euro currencies. My eye is specifically on Germany this year. They have a general election coming up and I'm wondering if any of the major parties will create a stir by advocating a return to the Mark. Mal sehen.

The British Pound may be in an even worse situation. Home prices are crashing all over the UK, putting even more pressure on the already ailing financial system. The pound lost 25% of it's value to the USD over the course of 2008. I can see that happening again in 2009. I would not be surprised to see the pound trade at par with the USD.

I wish I had something positive to say about the Canadian Dollar. But I don't. The Conservative government's handling of the developing crisis has been pathetic. I had thought that, if anything, they would at least try to keep the country out of deficit. Instead, it has become a virtue of sorts, in the minds of Harper and Flaherty that deficit spending is somehow "proactive." It has become apparent that the only direction for any government in Canada, be it Conservative or a coalition, is toward bigger deficits, private sector bailouts, etc. As a result, the only direction for the Loonie is down. The Loonie also underperformed on the latest correction in the Greenback. This does not bode well for the next leg down.

The Swiss Franc and the Yen were the best performing foreign currencies in 2008. Even though interest rates are at or near zero, that was of no concern to investors stranded in carry trades. I'm a little concerned with the absolute tanking of the Japanese economy. They have got to be getting desperate. But like the US, I don't see how they can do anything that will be effective in reversing the trend. Currency interventions never work. But that might not stop them from trying. Like last year, I'd be more willing to put my money in Francs even though the upside might be more limited. But that's just my personal preference. Not even the Swiss have avoided economic turmoil.

In summary, I think the trend toward more saving and the paying back of debt will prove bullish for the US Dollar. But that is no glowing outlook for the future of the currency. It, like all other paper currencies, will eventually become worthless. If you are planning on saving money for a long period of time (ie. more than 5 years), gold is the ultimate currency in my mind.

2009 looks to be an interesting year in the Forex markets (okay, I could probably say this every year). I'm expecting to see more dramatic collapses in minor currencies (Hungary, Pakistan, Argentina, Vietnam - I'm looking at you) and wild swings in the majors. What effect will this have on gold and other commodities? I'll attempt to tackle that question tomorrow.


rick said...

I was hoping that you would see a brighter future Canadian dollar. After all, it is somewhat linked to commodities which have real value.

Matt Stiles said...

Hi Rick,

That is only true to a point. The Canadian economy is reliant on only 33.8% exports. A percentage of that is exported commodities (I don't know that exact figure). But it is safe to say that probably 15% of the economy is commodity exports.

To me, that is not enough to label it as a "commodity based currency" like so many analysts tend to do.

It is a "debt based currency" like all the others. And it's value will revolve around international opinion on our government's ability to repay that debt, and at what interest rate - relative to other currencies.

It would be of great benefit to me to see a higher Loonie. I just don't know what the catalyst would be for that to happen.


Anonymous said...

Hi Matt

What are your expectations for the exchange rate Euro- USD for the first quarter of 2009 ?

Matt Stiles said...


That is going to depend on how long it takes for the next round of deleveraging to occur. And the extent will also be determined in part by how much the ECB cuts interest rates. Currently, people are in the Euro because of the interest rate differential.

I expect that the recent high in the EUR (1.44) was probably the highest we'll ever see it again. But if that level were to be broken, I'd have to re-evaluate.

Happy New Year!

Medieval said...

Hey found your blog when I was looking up recent US vs Canadian trends.

I sure hope you are right about the Canadian dollar continuing to depreciate against the US, as I work in the US and live in Canada :)



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