The Dollar Next Year: Two Angles
An update from World First.
As we move into December it is necessary to bring you our thoughts as to movements of certain currencies in the coming year. We will aim to bring you views from both sides of the argument i.e. an argument for strengthening and an argument for a certain currency’s decline. In the first of this series we will look at the prospects of the most important global currency, the US dollar.
The case for the prosecution: a weaker greenback
The US is in a terrible state at the moment with a budget deficit as a percentage of GDP larger than anything since the end of WW2, while the money that it owes in the form of US treasury debt has almost tripled in the past year and is expected to expand by around $1trn a year for the next 15 years or so. This coupled with the expansion of spending needed to fund Obama’s healthcare plan, the ‘War on Terror’ and social security for baby boomers leads us to believe that they have two options; print more debt or hike taxes and slash spending.
As a fan, interested observer of American politics and a firm believer in Josiah Bartlet I think we can safely forget the last. Obama is not going to raise taxes on “middle America” this close to the mid-term elections and would not afterward for fear of giving the Republicans the White House back after his first term. Likewise he cannot cut spending at the fear of alienating moderate democrats and liberal Republicans when he needs to so much support on ramming through his healthcare plan Superman is in trouble and will have to do what all have done before him; spend like a drunken sailor.
This will continue in 2010 and therefore we are likely to see interest rates in the US continue to remain low for a very long time. This should lead to a weaker dollar as other countries raise rates and attract inward investment on their debt. The US is now likely to move into a time in which it is comparatively a lot poorer than it has been in the past 100 years and could see its position as the global reserve currency threatened further.
The case for the defense: a stronger dollar
Those of my profession who are looking for a stronger USD over the next year or so are focusing on the first quarter of 2010 as the time in which the starting pistol will be fired. Quantitative easing should end in the US by March. QE has had a negative effect on long-term interest rate expectations and the belief is that as soon as the Fed stop their repurchase program we will see the market price in interest rate hikes towards the latter part of 2010.
Higher US rates may serve to weaken the prospects of emerging market investments (why take the risk when the return is comparable?) and benefit from its status as a haven currency Positive correlations to this probability have been seen over the past 10-15 years.
The other thing to bear in mind is the price of this debt in yield terms. The US are due to auction off close to $2.5trn over the course of 2010 with the Fed hardly absorbing any. This leaves other investors to pick up the slack. The Fed will not risk these issuances being undersubscribed and will post attractive interest rate coupons to the debt to attract the cash. That increase in interest rate should see a surge in dollar buying and a stronger dollar as a result.
Looking at the option market we have seen an increase in the cost of protecting against dollar strength, a sign of a market preparing for an onslaught. The price has risen so much that it we are not far from the price levels that were seen in the immediate aftermath of the Lehman bankruptcy for a three month horizon. It seems that the market is sensing a strong movement in favor of the US dollar around the end of Q1; an expectation that fits in with the possible Fed curtailing.
Conclusion: We believe that 2009 has been difficult to predict, however, it may be nothing compared to 2010 for the dollar market. With cues from the options market in particular we think a hedge via an options contract is the only sensible protection measure that can be taken. We are of the opinion that dollar will weaken in 2010 as the world continues to recover and the need for haven assets lessens but would still advise a protective hedge, an example of which is below.
Next week we will turn our thoughts on the euro.
Trade of the Week
This week’s trade of the week is a risk reversal from January to June. The client sells GBP and buys USD to pay suppliers in Taiwan. They had budgeted on the next six months of invoices at a GBPUSD rate of 1.62 on our advice, but were unwilling to use forward contracts to protect themselves as they believed that the pound would rise at some point against the dollar.
The client was able to achieve a worst case rate of 1.62on their option and they benefit up to a rate of 1.80. Should the GBPUSD rate be below 1.62 on expiry they are able to buy dollars at 1.62, if it is above 1.62 and below 1.80 they buy in the spot market and if it is above 1.80 they are obligated to buy at 1.80.
This strategy required a premium of 2.7% of the notional amount (the amount hedged), and is also relevant for sellers of sterling and buyers of other currencies. As there is a potential further weakening for sterling in the future, it provides a balanced upside for this potential, while guaranteeing a tight worst case rate.
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