Currencies: A Retrospective on 2006: A Cyclical Dollar Downturn

Stephen Jen | London

This is a time for reflection on 2006

I am saving my 2007 outlook for the first week of January. Instead of looking ahead, I think it is useful, at the end of the year, to take a moment to reflect on the year that has just gone by, and to evaluate my calls this year and draw lessons from how the currency markets behaved this year.

What I said at the beginning of the year

1. “The story for the dollar this year will be cyclical and closely linked with the developments in the US housing market.” I argued that the ‘trendy’ phase was over and for 2006, I saw a “gentle turn in the dollar in sync with a soft-landing in the US housing market. I also argued that the US current account deficit would reach an ‘inflection point’ in 2006, which should diffuse much of the angst about the dollar from a structural perspective.

2. “2006 will be the Year of the CNY. More flexibility and more meaningful appreciation of the Chinese currency are expected.” As the CNY appreciates, it will push all the Asian currencies stronger against the dollar. JPY will be the laggard in this bunch due to its very low yield … China will become the largest foreign reserve holder in the world later this year, surpassing Japan.

3. “The dollar’s movements this year will likely be asynchronous against various currencies.” “In contrast to the previous four years, the dollar’s movements are likely to be asynchronous against different currencies. In other words, the USD is likely to peak at different points in time against various currencies.

My good and bad calls this year

In my view, my call for a cyclical dollar correction centered on the US housing market has been broadly correct. I argued a year ago that EUR/USD was forming a bottom in the 1.17-1.18 range. I was also correct in expecting USD/AXJ, led by USD/CNY, to trade lower this year, with USD/JPY being the laggard due to the low yields in Japan. Importantly, my prediction that the US current account deficit would reach an inflection point this year also seems to be correct.

I was, however, wrong on several fronts. (1) I had underestimated the market’s support for EUR/USD and the ability of the Euroland economy (Germany in particular) to recover. (2) In contrast, I was too aggressive on USD/JPY this year, thinking that USD/JPY would go on being weighed down by positive real economic fundamentals, and that the relative low nominal yields would matter less over time. (3) I underestimated the scope for EUR/JPY to trade higher. Even though I proposed the ‘Global Funneling’ concept as an explanation for this upward structural drift in EUR/JPY, I did so quite late (August). (4) I had expected the three commodity currencies to depreciate against the dollar, as the global economy decelerated with the US, and because these currencies were already over-valued. Further, I had expected that the prospective unwinding of the JPY carry trades would weigh on these high yield commodity currencies.

Lessons from 2006

There are several key lessons from 2006 that will be important to keep in mind for 2007.

• Lesson 1. Financial globalization will remain a powerful driver of exchange rates. By financial globalization, I mean the sharp rise in cross-border capital flows, both private and official, in recent years. Trade balances and globalization of the goods markets are clearly important, but I believe that capital flows and financial globalization are even more important in dictating where exchange rates go.

First, it has been a global trend that ‘home biases’ have declined in most countries. This has made current account imbalances a much less powerful predictor for exchange rates.

Second, as virtually all countries are diversifying, it has been difficult to draw clear, definitive conclusions for currencies. As a result, investors have thus been forced to extrapolate from announcements made by a few central banks and countries that are unfriendly toward the US, such as Iran, North Korea and Venezuela. My view on this subject of central bank diversification is quite different from popular opinion in the market, but I concede that since the prevalent view can neither be proved nor disproved, comments and rumors will continue to fuel bouts of mini-attacks on the dollar, interrupted by sporadic surges in the dollar based on economic fundamentals.

Third, as the official reserves of several key central banks in the world exceed what are needed for liquidity purposes, many central banks will likely deploy the additional or new foreign reserves to investments that are higher-risk but with higher expected returns. This evolution from pure reserves to the ‘sovereign wealth funds’ has begun, and will have very significant implications for not only the currency markets but also bond and equity markets in the years ahead.

Fourth, in thinking about the fair values (FVs) of exchange rates, it is also important to consider a concept I proposed several years ago: Multiple Shadow Prices. The basic idea is that, while most fair value calculations, including ours, are based on real economic fundamentals, given the importance of global capital flows, a parallel concept is that some countries may have very different exchange rate FVs, from the perspective of capital markets.

• Lesson 2. Cash yield differentials will likely remain important. I have long resisted accepting that nominal cash yield differentials could be such the dominant driver for exchange rates. To me, over time, real economic fundamentals (such as productivity and the terms of trade) should be important and carry should not. How the currency markets have behaved in 2006 suggests otherwise, however.

First, cross-border asset holdings have grown drastically in recent years, the need to hedge should also have increased. Since hedging costs are dictated by nominal short-term interest rates, cash yield differentials may have become a more powerful driver than in the past.

Second, I have recently realized that the sensitivity of exchange rates to nominal cash interest rates may also have been due to the enhanced transparency of central banks in their communication strategy.

• Lesson 3. Don’t bet against the Fed. To me, the Fed has been the best forecaster of the US economy. At virtually all turning points since 2002, the Fed has been ahead of the market and made the correct call. I am not saying that the Fed does not make mistakes, but merely pointing out: (i) the remarkable level of confidence the Fed’s detractors have in this environment of uncertainty; and (ii) the recent superior track record of the Fed, compared to anyone else in the market.

• Lesson 4. Beijing to be more flexible in the years ahead. I believe that the single most important development in China this year has been the explosive growth in its trade surplus. There is no way around: (i) China’s additional reserves being converted into a ‘sovereign wealth fund’; and (ii) the rate of crawl of USD/CNY accelerating further.

• Lesson 5. Don’t underestimate any economy, even Euroland. Back in early 2005, Japan surprised many with its economic recovery, as did Germany a year later. The point here is that a lesson I have learned is not to dogmatically cling to preconceived notions: a structurally flawed Euroland can exhibit surprising resilience. The durability of the recovery we are witnessing is the next test for Euroland, but commentators (like myself) and investors should be open-minded about this.

Bottom line

Many of the key themes that have dominated this year will likely carry over to 2007. I will present my 2007 currency outlook in more detail early next year.