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Busch: Race To The Bottom Revisited
As we close out 2008, there is a return to a theme that had started in the summer. GERBO or the Global Economic Race To The Bottom was initially won by the US in June/July and the US dollar had begun a rebound in July/August when the economic data out of Europe began to show signs of quick deterioration. The US dollar rally had a strong move at that time and then stalled for about 2 weeks when the credit crunch began with the Lehman failure.
While I had called for a US dollar rally through the fall, I nor anyone else didn't realize we'd see a massive de-leveraging from the credit crisis. This forced massive redemptions from investors in hedge funds that led a massive dumping of previous profitable positions in currencies. The long run positive currency plays have been yen carry (short yen/long other ccys) to short US dollars. These were unwound with a vengeance.
At the same time, the US government was aggressively pursuing varied approaches to dealing with the crisis. This included the now infamous TARP program by the US Treasury and essentially a ZIRP (zero interest rate policy) by the Federal Reserve. However, the biggest shift of significance for the currencies is the central bank's newly announced quantitative easing program where the Fed will begin buying assets to increase their balance sheet. Prior to August, the Fed's balance sheet was below $1 trillion. Now, it stands over $2.2 trillion and should continue to dramatically increase.
There is debate whether this new policy is inflationary or not. Those that think it will have no impact point to the Fed using free reserves to buy the assets and not increase the money supply. They also point to the drop in the velocity of money as another indication that this will have no impact. The inflationistas believe that buying assets will pump up the money supply and have a major impact of flooding the currency markets with US dollars. I reside in the latter camp and proudly wear my Milton Freidman monetary policy t-shirt: Inflation is always and everywhere a monetary phenomenon!
Being a simple Midwesterner, I look to the markets to understand what they say about the decision to ease quantitatively. Since the Fed announced their decision to buy MBS and other debt, the US dollar has lost 15% against the Euro and gold has rallied 25%. To me, these markets have assessed the risk and decided that the Fed's actions risk serious problems down the road. The markets also may be voting against the credibility of the Fed to handle the situation. Given the recent monetary easing between 2002-2004, I think markets should be extremely skeptical of the Fed's ability to manage monetary easing. This is why I think the biggest risk for the markets in 2009 will be a large devaluation of the greenback as we head into the second half of the year.
With the 10th anniversary of the advent of the Euro, the focus this year should be on how this currency strengthens against the British pound and the US dollar. Unlike the US central bank, the European Central Bank is not likely to cut rates to zero nor to engage in quantitative easing. This is why I think the Euro will benefit the most from a US dollar devaluation with a target of 1.60-1.80 for Q3 2009. This is CURBO: currency race to the bottom and the US should win easily.
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