Currencies: A Race To The Bottom?

What’s going on the forex markets? You could be forgiven for thinking that the dollar would weaken as the US government announced another few trillion of spending, but no. The dollar ended yesterday (Tuesday) stronger against all the main currencies except the yen.

Stuck To The Dollar
As currencies devalue, people have to buy even more dollars to pay down their debts. So there’s a self-reinforcing trend. And even though the Fed is printing money, there still aren’t enough dollars to go round. When dollars were cheap and US consumers were spending, it was easy to borrow. The banks were happy, ‘cos they could get hold of cheap dollars and convert them into loans in their home currencies, then package up their loan books and sell them on as AAA-rated securities to raise yet more cash. That’s how HBOS, RBS (RBS), Northern Rock etc grew their lending and fuelled the UK property bubble.

So, a growing problem for the UK banks is that they have loads of commitments (e.g. complex deals involving asset backed securities, US packaged loans, credit default swaps) denominated in dollars which now cost more to service. If your balance sheet is in pounds sterling, dollar-denominated debts is effectively costing you more.

A weak pound = poor health for the banks. It’s often observed that when sterling strengthens, so do the UK banks, and vice versa.

It’s not in their interest, or that of any big corporate with dollar-denominated debt, for the pound (or the euro) to carry on depreciating against the dollar. So another reason for some of the wild swings we’ve seen could be big corporates having to hedge these big risks. Currency trading is dangerous at the best of times but right now it can be lethal. There are a lot of nervous elephants stomping around in the forex jungle.

What Would You Do If You Had Euromillions?
Here’s a question to ponder. What would you do if you won a million pounds (or euros) in the current climate? Go out and spend it? Where would you put it? How would you use it? Your answer may provide some clues about how to read the macro picture. Is your No. 1 priority would be to pay down debt? It would be mine. The second thing I’d do is take a long holiday, then I’d look for something innovative to invest in. But not until I’d paid off all my debts - mortgage, credit cards, overdraft etc. I ‘d want to reorganise my finances to become much leaner and more efficient.

And that’s roughly the situation a lot of big corporate entities find themselves in. They’re desperate for capital and they have to reduce spending and conserve cash at all costs. Of course they’ve just lost the debt lottery, not won it, and to make it worse their share capital is also in tatters (which is one of the reasons we’re seeing so many rumours of rights issues).

Big Eurotrouble
The debt situation in Eastern Europe is getting worse by the day. A nasty side effect of currency devaluation (Iceland has been the textbook case for this) is that it creates unwanted stress in credit markets. The rouble, the Polish zloty, the Hungarian Forint and any number of other currencies are collapsing. So any debts denominated in foreign currencies become much more expensive to service, raising capital becomes more expensive, and you also get import price inflation - i.e. the cost of buying commodities in your home currency goes up. (This pressure is being offset by the decline in the cost of raw materials - it’s exactly the opposite dynamic to the commodity bull market - high demand, weakening dollar - we had in the first half of last year).

On the other hand one could argue that a softer currency makes labour costs more competitive, and it’s also good for exports. But right now trade is at a low ebb - no-one’s buying anything much, and stock levels remain at all time highs. That translates into lay-offs and factory closures; thus rising unemployment and creating a self-reinforcing cycle of economic decline. To make it worse the eurozone is getting into a heavy political deadlock about macroeconomic policy, with rows about protectionism and how to manage an economic stimulus, and growing civil unrest. There’s a single currency but no single government to make decisions. Many Eurozone banks are wildly overexposed to eastern european debt, with the risk of default coming closer and closer each day. And eurozone interest rates are still too high, in my view. For this reason I’m even more bearish about the prospects for the eurozone than I am for the UK, and just keep adding to my short euro positions.

A contrarian question: what would happen if the euro went to parity with the dollar? I don’t know the answer, and I don’t think it’s impossible.

How Am I Trading This?
On currencies, I’m running very simply with a longstanding short EUR/GBP position (from 9450), and a short EURUSD position from 1.3730, which I’m adding to when I see selling opportunities. I’m inclined just to leave them to run for the moment.

I can see that more gold buying could easily be on the cards, particularly if equity markets lose their appetite for gains. As I hinted in a previous blog, on balance I’m more sympathetic to the bear case for gold, because I don’t think the dollar is going to weaken quite as much as a lot of people seem to expect. Cash is king, and cash = dollars. In the meantime it’s entirely possible that there is more to be played for on the upside in gold. But I’m not going for it. Rather, I’m looking for shorting opportunites.

So the aim of the game is to try to stay relaxed, and not to overtrade. I think there’s plenty of downside risk. Earnings going forward look like they’ll be dreadful (which means that the S&P could head down to 600 or below); and that’s another reason to maintain a short gold position. In a deflationary, depressed economy, why would gold need to trade above $900 an oz? $600 or below would be more reasonable. Everyone will have to sell it at some point to raise cash anyway, won’t they? If, on the other hand, lending levels do recover, consumers begin to spend again and China doesn’t collapse then we might, perhaps, see some modest inflation and some currency debasement. In that scenario gold might be just the ticket, although to be honest I think gold is already pricing in big inflationary pressures which aren’t really there.

Dollar vs Gold
So a (relatively) strong dollar and strong gold? Odd. One or the other is likely to give. I suspect that gold that will be the loser. I don’t see much chance of a full-blown commodity bull market for another six months yet. But I could always be completely wrong…

What would upset this view? Well, if there was a serious move towards euro-buying then it would be an indicator of risk appetite returning to equities, and then a long position in gold might make much more sense. Or if there was a loss of confidence in the dollar as a ‘reserve’ currency. But are we at that point yet? I suspect deflationary unwinding and deleveraging has further to go.

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