Friday, July 21, 2006

Dollar safe haven? I don't think so!!

Yes ! the dollar has gained some strength on the back of more risk aversion.
Yes ! interest rate arbitrage continues to be a big determinant in which currency will underlie investments.
My view is that there is more downside than upside risk for the dollar. This is because of:
  • The growth-inflation trade-off issue that is bothering Bernanke, with sources of inflation being partly exogenous. The US gasoline market is hugely exposed to oil price movements, which openly and directly exposes US consumers to [almost] the full effect of changes in oil prices.
  • Core inflation will continue to be under upward pressure from rising imported goods prices.
  • As the Fed struggles with the inflation-fighting mandate, the economy has long shifted from the goldilocks position into possible stagflation.

and possibly most importantly:

  • Anything that is going to be a challenge for America is bearish for the dollar. What are the current challenges: 1) the ever worsening Iraq situation, 2) American-Iranian relations, 3)American-Russian relations, 4) American-North Korean relations and 5) The effect and subsequent costs (in money terms) of taking Isreal's side in the current 'situation' between Israel and Lebanon.

Over the medium to long-term, challenges such as those posed above will weigh down on the dollar's image as a safe haven currency. They will have a net negative effect and that will translate into poor confidence in the country.

Over the immediate term, some may cite that moneys from oil and commodity producing countries are being loaned to America in exchange for bonds. However, all that will achieve is another bond market bubble, with an inverted yield curve (because the long end is falling, relative to the short end).

Does the above constitute a good investment strategy? I think not.

Let me point some focus on two things :
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1. Between the end of 2002 and June 2006, a long real/short dollar carry, and a long lira/short dollar carry strategy would have yielded between 26%-30% average annual returns (sharpe ratio approx 1.95), outperforming most (if not all) major FX trading strategies.
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2. Due to the flight of investor capital away from emerging markets, assets within these locales are relatively cheap, with even more potential for big gains upfront.

Emerging markets are now sources of cheap assets, relative to the period before the recent resumption of risk aversion. At some stage (very soon) investors will begin to purchase these assets and hold for the band wagon effect, at which stage they'll have made big returns and may be slightly indifferent about closing their positions or continuing to hold the assets. Why will they be indifferent? Because a simple cross-over trading rule can be implemented to limit losses.

Soon, money will rush back into emerging markets. Watch and see!

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