Currency Volatility Returns

The euro, which traded last Friday at 1.4775 against the US dollar, not far from its high of the year (1.5145), has now fallen to 1.4340.

Dollar/yen is up from 87.75 to 90.15 in a week, sterling is down against the dollar but slightly up against the euro, while the Aussie dollar has fallen against its US equivalent from 91.88 cents to 88.48.

And gold, which hit an all-time high (in nominal, non-inflation-adjusted terms) of US$1,226.50 an  ounce earlier this month, is now close to shedding 10% from its peak, with a current quote of US$1,112 an ounce.

Interestingly, although there have been many reports of a structural short position in US dollars, which might in turn set the stage for a rebound in the currency (a Reuters report today used this argument to explain the sharp move up in the dollar over the last 24 hours), the just-released Merrill Lynch investor survey apparently tells us that fund managers are, on average, already expecting a stronger dollar (and have presumably positioned their portfolios accordingly).

This week’s euro decline is easier to understand, given the strains in Greece that are already leading some to speculate that the country could be forced to exit the single currency zone.

Incidentally, if the stronger dollar is the start of a trend, does this mean that the other main reading of the Merrill Lynch survey – respondents’ expectations that 2010 will be a solid year for global equities – also come to pass?

In hedge fund manager Hugh Hendry’s world, the rise in nominal bond yields this year has been an effective tightening of monetary policy. Hendry, who is expecting the dollar to go up as the deleveraging trend reasserts itself, also believes that we are headed for an extended period of ultralow interest rates, low nominal GDP growth, deflation and “very poor prospects for corporate profitability”.

Espen Baardsen, Hendry’s colleague at Eclectica Asset Management, told me earlier today that his firm’s main asset allocation views are therefore a long US dollar position and also a long position in long-maturity German government bonds. Eclectica views the asset classes that have benefited most in price terms this year – emerging market equities, raw materials – as “something of a bubble”, he said. “The theme this decade has been to be short the dollar, long the emerging markets, commodities and China, but we expect that things will change as we move into the next decade.”

The overall implications for equity markets of this return to deflation are negative, Baardsen argues, although some sectors and stocks, particularly those with high yields and pricing power (tobacco stocks, some telcos, pharmaceutical companies) will do well.

Whether this week’s sharp fx market moves are a sign of thin pre-holiday markets or of more fundamental changes remains to be seen. But investors in all asset markets will surely be keeping a close eye on the dollar as we move into the second decade of the new millenium.

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