from Follow the Money

The club of puzzled dollar bears grows bigger

November 1, 2006

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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I am – and probably always will be – a big Robert Rubin fan.  In my view, 100 bills with Rubin's signature should trade at a premium, not a discount.

But Rubin doens seem to be as good a currency trader as Treasury Secretary.  All of us who thought there was a big risk that the US would have a Wile E. Coyote moment two years ago can take comfort that both Bob Rubin and Paul Volcker thought so too.  David Leonhardt:

“Whatever the outcome, a decline in the dollar will probably be part of it. That’s why Mr. Rubin made his bet. But the dollar didn’t cooperate. While no longer at the highs it reached in 2002, it has stayed strong. Mr. Rubin ended up losing more than $1 million (which, certainly, he can afford) before getting out of the currency market.

… But when he talks about the dollar, you can see how hard it is, even for somebody with his self-assurance, to remain confident in the face of a failed prediction. “I think I was right, probabilistically,” he said recently, sitting in his Citigroup office overlooking Park Avenue. “But I don’t know. I really don’t. I don’t think anyone does. It’s also possible that none of this could happen. It’s possible that for reasons none of us can see that this will work itself out in a very copacetic way.”

Mr. Rubin and the other dollar bears look a little like the skeptics of the real estate boom back in 2005. For years, those skeptics warned that things had gotten out of hand and that reality would soon reassert itself. And for years, they were wrong. The longer they were wrong, the more out of touch they sound. “

Copacetic – for the record – means "fine, excellent, going just right."  I had to look it up

Dollar bear bets haven’t been consistent money losers.    The standard bets paid off quite nicely between 2002 and 2004.   But they didn’t work so well in 2005 (I know this very, very well).  Though if you held European equities, they still outperformed US equities in dollar terms.  Bets on the yen haven’t worked this year, but bets on the euro have paid off.  1.27 is a bit higher than 1.17.

What generally hasn’t paid off are bets that emerging currencies will adjust.  Largely because emerging market central banks haven’t let their currencies adjust.   No mystery there.

But in broad terms, the dollar bears haven't been right on the big picture.  Not since the end of 2004.  Bigger deficits haven't pushed the dollar down.  The market hasn't demanded adjustment -- rather it has financed the absence of adjustment -- at relatively low rates.

Of course,  the absence of much adjustment in emerging market currencies is a big reason why the US current account balance has continued to deteriorate.    US exports have responded to the dollar’s fall v. the euro.  But the combination of the dollar’s strength v. emerging economies and a huge credit line from emerging market central banks has been rather copacetic for emerging market exports to the US.    

Indeed, a recent Marquez/ Thomas paper suggests that dollar remains roughly as strong as it was in the mid-80s once changes in the composition of US trade are taken fully into account.  See this Menzie Chinn post.  Even if the dollar has fallen a bit since mid 2005, the basic point still holds. 

That said, I share Rubin’s deep sense of puzzlement.  Not about the dollar.    Central banks are clearly responsible for propping it up against the places that count, and the dollar isn’t that strong against places that don’t actively intervene.  OK, the dollar/yen puzzles me a bit -- carry isn’t always king.   

But what really puzzles me is the absence of volatility in the foreign exchange market.   The pound trades like it is euro, and the euro/yen/dollar volatility has fallen.  That of course is tied to the attractiveness of the yen/ dollar and yen/ euro carry trades. 

One common explanation is that inflation rates have converged in the major economies.  I don’t think that works though.  Inflation rates in the g-3 converged a long time ago.    And it may be diverging a bit – overall US inflation was sort of high a while ago. Volatility disappeared only recently.

What really has converged is not inflation rates in the G-3, but emerging market inflation rates and G-3 rates.   A lot of the big emerging economies – China, Mexico and Brazil to name three – now have lower inflation than the US.   That is a real change. 

But I don’t think that explains the absence of volatility in the RMB/ dollar.   That is all the product of the PBoC (volatility is actually up a bit, but on an absolute level, it remains quite low).  More generally, when emerging economy currencies are under pressure to appreciate and the central bank intervenes to stop the appreciation, there won’t be much volatility.

Stephen Jen goes one step further – he argues that emerging market central banks are the reason why there isn’t much volatility among the g-3 currencies.     His thesis is that the big players lean against the wind – buying dollars when others want to sell (2003, 2004, the first half of 2006) and buying euros when others want to sell (2005).   That is consistent with the (available data).   Central banks have been buyers of last resort, not destabilizing sellers.    When the dollar is going down, they have – at least to date -- stepped up their purchases. 

I am not sure that is the entire explanation, but I do think it is part of it. 

Of course, there is an offsetting risk.  Suppose the market starts expecting central banks to act in ways that dampen volatility, and makes bets based on that assumption.   Big ones.   And then suppose central banks – under stress – change how they operate.  

The dollar falls.   And rather than deciding that they need to buy more dollars to keep the dollar’s share in their portfolio up, central banks decide to cut their losses.

To be clear that isn’t how they have acted to date.   The risk is that policies might change when the market no longer expects change. 

Another former Treasury Secretary – Larry Summers – likes to emphasize that fixed exchange rates only appear to dampen volatility, as they can also store up a lot of volatility that gets unleashed in a short-period of time.    In a speech to the Asia society in Hong Kong, Summers noted:

“I would suggest one relevant, overarching lesson of the financial history of the last half-century. There are literally dozens of examples of countries that maintained fixed exchange rates or quasi-fixed exchange rates for too long and then were forced to exit them in a disorderly way or found the consequences of their exit to be wrenching” 

Summers was talking about countries that maintained over-valued exchanges for too long – not countries that intervened to keep their currencies under-valued.   But if one country is intervening to keep its currency weak, it effectively is keeping another country’s currency strong.   The US has intervened to keep the dollar strong – it has outsourced that task to the world’s poor countries -- but the dollar is effectively pegged against much of the world and the US still might suffer from a disorderly exit …

He was thinking about volatility in the currency pair that is linked by pegs.  It is low only so long as the peg lasts. But given that central banks asset allocations now likely influences other rates, it seems like his observation may be right more generally. 

But I am ending up by defending an insight that comes from a period when the world adjusted – and the pegs of  many emerging economies collapsed.   I still the lessons of the late 1990s hold, but, so far, predictions based on those concerns haven't worked out so well.  

Put a bit differently, I would expect, based on the collapse of capital flows to emerging economies in the 1990s, that a more unbalanced world will prove, over time, to be a more volatile world.   But so far, though, it has been – at least in some key markets – a less volatile world.    That puzzles me.  I don’t think the world is fundamentally now more copacetic. 

But at least I seem to be in good company.

NOTE: I edited the introduction to work in today's Wall Street Journal story 

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