Sunday, August 17, 2008

The dollar’s decathlon

You don’t have to go to Beijing to get a taste of “Olympic” action these days. Whether you like dives, sprints, hurdles or jumps, all you have to do is turn on your computer screen and follow the …dollar! With one difference: Unlike the Olympics, where America appears to be ceding its gold-medal supremacy, the dollar has been the unambiguous champion in currency markets this summer.

After diving spectacularly in March, as the housing and financial crisis translated into an investor stampede out of dollar-denominated assets, the dollar turned into a “hurdler,” with its attempts to come back hindered by a series of bumps. By August, however, it was time for the jumps! And what a jump we got: A three-standard-deviation jump, on August 8th, followed by a steady run back up to levels seen in January… as if Bear Stearns, Fannie & Freddie and the US housing crisis are now a distant memory.

Many a currency expert “sprinted” last week to pronounce the end of the dollar’s decline with such literary headlines as “Is the Greenback?” or “Godot has arrived!” I can’t help noting of course that IF they are right, they were a couple of weeks late!

But are they right? Has the time come for a steady and broad-based strengthening of the dollar after six years of weakness? Should we be really looking forward to pepping up our wardrobes with cheaper Italian suits as early as this Fall?

The beauty contest: Most will admit that the speed and scale of the dollar’s recent jump has been a surprise. Sure, we got unambiguous evidence that the rest of the world is slowing too, all the way from Europe to Japan, via Australia.

But hey, in the beauty pageant of world economies, America is not exactly the beauty queen! True, she has personality, but she also has a collapsing housing market, declining employment and a frail banking sector which remains in the ER, after $250 billion of write-downs and still more to come.

Importantly, while investors now sound more pessimistic about growth outside the US, their expectations about the direction of monetary policy abroad has not changed that much (with a few exceptions)—and certainly not enough to account for the dramatic moves in the dollar over the past couple of weeks.

Expected interest-rate differentials between America and other countries (one important driver of the currency’s “turning point”) remain clearly in favor of most G-10 currencies except for the Japanese yen. This means that you’ll be losing money if you keep on betting in favor of the dollar, unless the dollar continues to appreciate at a fast pace.

The oil-dollar affair revisited: Then we had the collapse of oil prices (and commodities more broadly) in recent weeks, which seems to have triggered the unwinding of long-oil-short-dollar positions by the herd of believers in an Oil-Dollar affair. As I argued back in June (here), the (available) evidence is too weak to corroborate the gossip, let alone support a trade idea.

Moreover, when it comes to proclaiming momentous events like the dollar’s turning point or Godot’s arrival, a drop in oil prices is not going to be your trigger: While it would clearly benefit the dollar vis-à-vis the currencies of net oil exporters, it is not a compelling catalyst for a broad-based dollar strengthening, notably vis-à-vis the currencies of “fellow” net oil importers such as the eurozone or Japan.

Still, one can’t deny that a large number of long-oil-short-dollar positions were on regardless, and that their unwinding may have contributed to the currency drama of the past couple of weeks. Similarly, with Europe stumbling and Japan tumbling, investors rushed to declare America their beauty queen, confident that a slew of men—from Hank to Ben to the entire US Congress—will catch her if she falls.

So here is the question: If it’s true that fundamentals did not move decisively enough to justify the size and speed of the dollar’s move, why wasn’t anyone willing to take the other side of the bet? Could they change their mind as the “dust” settles?

Following the (order) flow: Part of the answer may lie in the so-called “microstructure” of exchange rate markets. The idea goes as follows: Economic researchers have invariably found a disconnect between the short-run dynamics of exchange rates and macroeconomic fundamentals. In other words, even the best exchange-rate models that rely purely on macroeconomic variables (such as interest rates, inflation, trade imbalances, etc) can only explain (and forecast) a very small portion of the short-term variation in exchange rates.

It should be no surprise then that we got a pretty dramatic jump in the dollar recently without a “matching” drama on the macroeconomic news front. But even if there is little surprise, this is not very useful for judging what actually happened and, critically, how long any “disconnect” can persist. This where the “microstructure” guys step in.

Accordingly, information that may be relevant for the pricing of currencies is dispersed across many economic agents, be it individuals, firms or banks. What determines the persistence of any “disconnect” between macro-fundamentals and the price of a currency is the speed with which this dispersed information becomes common knowledge and is embedded in the market price.

“Order flows” are an important channel via which agents’ private, dispersed information is aggregated and incorporated in the price. These are the orders for foreign exchange that you, me, your bank or a furniture-exporter place with our foreign-exchange dealers, based on our respective information about our foreign-currency needs and our expectations about the economy. Dealers (who are the ones who set the price) observe their customers’ order flows, as well as news on the macro-economy, and try to make inferences about the direction of the exchange rate. Dealers also deal among themselves and, through the flows they place in the inter-dealers’ market, their individual information becomes market knowledge and is eventually reflected in the price.

The problem is that the information content of order flows is often hard to interpret—for example, flows may be generated by a customer’s idiosyncratic foreign-exchange needs rather than due to a “fundamental” piece of information. This can slow the information-aggregation process and lead to exchange-rate quotes that are disconnected from fundamentals. The disconnect could persist for months, if firms end up incorporating these “wrong” exchange rates in their real decisions on trade, investment, etc.

Stop-losses and cascades: Idiosyncratic orders could also lead to “price cascading” of the type we saw on August 8th, when the dollar staged its “Olympic” jump. For example, some researchers have suggested that in a scenario where, say, a downward move in the exchange rate triggers "stop-loss" orders, the move can have a cascading impact on the exchange rate, whereby the price jumps fast and discontinuously from one quote to the next. This is because, under asymmetric information, dealers don’t know whether the orders are due to (idiosyncratic) stop-loss policies or private information on the economy. Thus, they may end up quoting prices that are unrelated to the true state of the economy, triggering more stop-loss orders, etc etc.

So what’s next? If markets are quick to digest the fundamentals, we could see a correction of the dollar from its highs over the coming days, particularly if “cascading” or other short-term “momentum” trading have contributed to exaggerating the jump. Alternatively, if the “digestion” process is slowed by continued uncertainty, the dollar’s newfound “strength” could persist for weeks(/months). Of course, we could also see a drastic economic deterioration in Europe and elsewhere, unaccompanied by supportive policies à la US, which may well justify the dollar’s move after the fact.

Paulson & co. have clearly come out to “ban” the dollar from diving. But as we’ve seen, there are other sports the dollar can claim leadership in, from jumps to sprints to hurdles. And don’t forget... the trampoline is also an Olympic sport!

Glossary: macro-fundamentals, micro-structure, dealers, agents, order flow, stop-loss orders, price-cascading, Waiting for Godot

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