Abaci's Common Sense Investing

There's really no way to predict how different currencies will act in this on going crisis, just as nobody could really see it coming or foresaw its magnitude (perhaps except Doctor Doom & the Black Swan). Therefore I can only list out the underlying forces at work. You are welcome to contribute what additional signs to watch out for.

(1) USD buying pressure to ease when de-leveraging is completed
This is easier said than observed. USD should drop when global de-leveraging is completed and most USD loans are reduced down to a safer level. But it's hard to say when. Even though most banks in US and Europe are re-capitalized and less leveraged, this is only relevant if value of assets they hold don't drop further. If we see higher grade debt instruments in US turn sour faster and deeper than expected, e.g. commercial real estate loans, credit card debt, municipal and state loan, etc, we know well this time it's not gonna be a localized problem in the US, as via securitization its effect will be broad reaching. And depending on whether the banks have learnt to hold more than enough USD for contingency, there's possibility for another USD rush when positions have to be closed. In addition, the on-going sell/scale down of foreign operations by US institutions will continue to support the USD as funds are repatriated back.

(2) USD borrowing to ease as interest rate is low everywhere
Companies are less likely to borrow in USD if they can get equally low rate in local currencies. In fact, a lot of existing USD debt will be refinanced with local currency debt. For example, in HK many companies are increasing their exposure to RMB debt to repay USD syndicated loan. This suggests lesser selling pressure for the USD. After witnessing the turmoil in the fx market last year, there aren't a lot of brave souls who would venture off-shore financing anytime soon.

(3) Spread of US treasury yield and corporate bond to narrow
It's happening and is a good sign that the bond market is breathing again, even only faintly. There are talks of quantitative easing everywhere, that the central banks will issue cheap debt and used the money to buy commercial loans/bond to push down the yield (i.e. borrowing cost). Whether that's gonna happen is not really important as investors have chosen to anticipate and act in advance, doing what the central banks want to do in advance and hoping to turn a quick buck when the central banks do move in. This seems neutral to the USD.

(4) US treasury buyer's stance, mostly Japan and China
Japan has no choice but to suppress the Yen, which is good for USD. Japan is an export economy and the US is its biggest customer. Its domestic market is too small to self sustain and it can no longer boast infrastructure spending. As most things Japan produces are human/physical capital intensive and it owns the brands, there's a lot of value adding so higher resources price in terms of a weaker yen is of lesser concern.

China on the other hand wouldn't mind a stronger RMB, for most of its exports are low value-adding and thus more sensitive to resources prices. A stronger RMB also brings cheaper imports (even for goods manufactured locally as resources are mostly imported) and boasts internal consumption, good prescription for the economy. However, China doesn't want to see a collapsed USD either as not only will the value of its USD assets largely deteriorate, Chinese suppliers will suffer badly too as they usually hold no brand, operating in fragmented industries, and have little bargaining power with US importers. A weaker USD will translate to lesser demand for goods and pressure for discount (i.e. Chinese side will need to absorb the loss from USD depreciation). If I were among the Chinese leaders I really wouldn't know which I prefer.

Another emerging trend is China is buying up natural resources everywhere in the world whenever opportunities arise. In time this may affect China's appetite for US treasury but at present there's not enough deals of magnitude big enough to cause such a swift. Moreover I note most deals, including the Russian oil deal and the Australian mine deal, are priced in USD (I suppose the reason being most commodities are priced and settled in USD), so China is only exchanging its USD reserve for something tangible, i.e. it doesn't involve buy/sell of new USD. And those selling countries/companies are in need of those USD to repay their USD debt as part of their de-leveraging. So this is really the other side of the same coin (i.e. factor (1)).

(5) Economic health of US and the others
This one is easier to spot - every economy is sick! And the common prescription is to borrow like crazy, either on the government level like in the US or much of Europe, or on business level via the easing of credit by banks like in China. If the borrowed amounts aren't enough to jump start the economies, there'll be a lot more money coming your way. In the end, it's the same for all currencies, i.e. a lot more money supply than before and nobody can be sure that the new money gets spent wisely. Therefore this factor is neutral as all currencies are not considered safe in this regard, i.e. low interest but no future.

But relatively, US is in a stronger position. If it is already hard enough for Obama to get things done quickly with just fellow democrats and the republicans, imagine how hard it is for Europe to agree on anything with all the different political ideologies. Moreover, the downfall of many smaller economies in Europe (including even Italy and Spain and of course the entire Eastern Europe) will drag down the Euro zone further. And the Russia position looks shaky and Europe as its neighbor is gonna feel the impact. If something drastic does happen in Russia, money will be flooding into the USD.

Summary
All the factors are mostly supportive of USD or neutral. The central theme seems to be if the US is bad, then everywhere else is just as bad and likely worse! Therefore I think the USD strength is logical and gonna sustain. WHEN and IF it does collapse, it won't be against other major currencies but rather against hard currencies, at present I think it's gold and oil (and there may be more). This is because the collapse is likely to be driven by the belief that most developed countries are close to bankrupt and thus paper currencies are no longer trusted. Monetary system takes a step backward and people will revert to holding hard currencies. So it's possible that a gold bubble is forming and maybe oil will follow steps too, and it doesn't require actual anticipated events to take place to support it, just imagination of it happening is enough to fuel it.

This isn't my favorite topic for obvious reason - one pays no interest and the other barely pays interest. But since most people can't be convinced to buy stocks perhaps it's good time for a change of topic

Have you ever noticed that American dollar is only currency that is called 'gold' in Chinese when it's not? You never hear (in Chinese) British Gold or Euro Gold. It seems the USD is the next best thing to gold.

The USD has started an uptrend, just like gold, since the collapse of Lehman last year, and it's stayed strong even when the US economy looked like it's heading into a tailspin, and amid the massive creation of money supply via everyday rescue and stimulus package's' and a close to zero federal rate.

The easy answer to this abnormality is that people flight for security in times of uncertainty. The US economy sucks and is shrinking but still it's the biggest economy in the world, and with the biggest army. The only other nations comparable are Russia and China, both communist and with currency control, hence it's not hard for most to make the choice. What about Euro? Well, as much as the high cost and unionized workforce is plaguing the US, the same hurts even more across Europe. And Europeans also fare generally less well than fellow Americans on creativity and technology front.

But this answer seems too easy and ignores something deeper in the working. I recently read an Economist article that provided better insights and together with my understanding here's a slight more difficult answer.

I'll start with the background. Globalization has lead to more emerging market countries, notably China and others in Asia, earning USD from selling exports. These USD ended up in various central banks' reserves and were not converted back, as most governments were still haunted by past trauma of the Asian financial crisis and the heavy foreign currency debt. So this time around they all loaded up USD as buffer for the bad times. Of course at the same time they also didn't want to their currency to rise too much and thus selling these USD was a big no no.

These USD then found their way naturally in the US treasury bond. As foreign trade increased and reserves soared, more treasury bonds were purchased which drove down the yield. During this time there was the bursting of the IT bubble and Alan Greenspan's monetary easing. I think everyone understood this well. So I'd just say both factors combined and the result was an extra low interest rate in the US, second to only Japan.

Out of cheap financing, a housing boom and a consumer spending boom was born. The housing boom was more devastating because it's also self-reinforcing, as higher prices led to more speculative buying.

Extra low interest also meant extra low return for lenders. American bankers then got creative and repackaged all kinds of loans into AAA securities and started selling overseas to those who had to buy USD but weren't satisfied with treasury return. Local US banks then eased its lending standard because lousy loans could always be sold. This part you now know very well too so I'll skip. I'd just add many US banks also provide USD financing to entice overseas buyers.

The low interest rate also helped grow the eurodollar / eurodollar bond market, i.e. borrowing dollar on non-US soil, mostly in Europe. As more companies/investors took advantage of the lower rate USD borrowing, this became self-reinforced as when borrowers converted the USD proceeds into local currencies to use, this drove down the USD and made borrowing USD more attractive as it's a currency that had low interest and was depreciating too!

So much for the long-winded background! Let's guess what's been happening since last year.

First the US banks got into trouble as the housing market deflated. But this was seen to be domestic only and hence USD fell even more as most people moved to other currencies with a higher interest rate when US was cutting rates. Then it became obvious that all the repackaged loans sold to Europe would go sour too, hence most European banks and investors would suffer as well, and probably as much too. These USD assets became illiquid or substantially worth-less. However much of these securities were financed by USD loan given by US banks at the 1st place (originally a nice hedge and leverage to enrich return). So Europeans suddenly found they were very short of USD. Of course it didn't help the US lenders were all in deeper trouble and needed that USD even more urgently.

Naturally the Eurodollar borrowing market ceased as the lenders, both US and European banks, or actually everyone, was short of USD! Normal commercial lending was affected at this point. So every asset class had to be sold to repay those USD loan, and hence USD had nowhere to go but up abruptly. The case was also worsened as borrowing was gradual over years but repayment was almost immediate. This was similar to the YEN unwinding every once in a while but of much broader scale, and with the difference that the original US lenders were also scrambling for the same USD like the borrowers. That's why we had a very high LIBOR vs US fed rate and the USD swap arrangement between the FED and ECB late last year. There's USD shortage everywhere.

What about all the monetary injection by central banks and the fiscal stimulus packages? I think evidence is the former is not enough to counter the size of the credit crunch, and the effect of the latter is not yet felt. Meaning - credit is still not enough so de-leveraging has to go on. This has been a rise or normalization of long term US treasury yield lately, which suggests maybe inflation or worst insolvency of US. But this is universal as I think credit spread for many European countries are rising as well, meaning everyone is having just as bad prospect.

What does these mean? The strong USD isn't going away soon! It's lucky we are in Hong Kong and most of us are automatically invested in USD via the peg. But I do think the tide will turn. I'll try organize my thoughts and tell you next time, and cover gold too.