Thinking about Shorting the Euro, Buying the Dollar (FXE & UUP)

Sunday, October 03, 2010

I started kicking around the idea of a short euro/long dollar trade idea this week and now that The Contrary Investing Report put together a nice post arguing for a rally in the buck, I thought I'd get my thoughts on virtual paper. I have the feeling this is going to be a long-winded, rambling post so be forewarned. I need to throw in everything and the kitchen sink to have it all written down.

UW's "Meeting of the Minds" as pessimistic as could be

Pessimism is absolutely rampant about America's future prospects. Last week, I attended an awesome forum put on by the University of Wisconsin at the Morgan Library titled "Chancellor's Series: Meeting of the Minds". Four members of the UW faculty came to NYC to talk about contemporary issues and reconnect with alumni from across the age spectrum (I think I was the youngest person there). The audience of ~100 had the great chance to listen to the thoughts and ideas of Barry Burden, Professor of Political Science; Tracey Holloway, Associate Professor of Environmental Studies; Joel Rogers, Professor of Law; and Stephen Ward, Professor of Journalism Ethics.

The forum, while interesting and provocative overall, was a downright depressing affair. For the most part, I'm well aware of the problems facing the United States but I didn't quite realize that it seems universally accepted that we are on an inevitable, unstoppable decline. The consensus opinion among the four seemed to be that America's political willpower is lost as the entire deliberative process has broken down and our economic future is one of decline as our debts and deficits cannot be mended. I came away wondering why a group of intellectuals, the supposed thinkers and problem-solvers of our world, simply presented us with all of this country's issues without presenting a solitary solution (besides forcing legislators who filibuster to actually go through the process, an idea I love and full-heartedly agree with). Are we all so sure this country is finished?

I hope UW puts on this event again next year but I would offer the following advice: give us solutions! I work in finance, in particular running a portfolio, I spend all my time worrying. Risk management is absolutely crucial for achieving profitability so I spend plenty of time contemplating the world's problems and trying to forecast the impacts. Yet, any and all successful investing is dependent on countries, firms, individuals overcoming problems, not never facing them. Simply taking linear trends and projecting them out is a very foolish way of looking out into the future.

Even the bullish call finishes with pessimism

While I enjoyed The Contrary Investing Report's call for a dollar rally, he finished up his post by appeasing the crowd by saying:
I should clarify that I am by no means a long-term dollar bull. I agree with the argument that over the longer term, the dollar will approach its intrinsic value of zero. And I realize the dollar has been trashed since the inception of the Federal Reserve.
Intrinsic value of zero, what?? This is point in this write-up where the Zero Hedge lovers stop reading and conclude I'm a blind idiot. But, others will recognize that someone claiming the dollar is worth nothing clearly carries the burden of proof. The dollar is backed by a $14.59 trillion competitive and innovative economy. Yes, $13.4 trillion in US federal debt is quite far from ideal but a debt/GDP ratio of 90% is not insane considering the major recession were are trudging through. Debt/GDP was over 120% in 1940 but we accepted the accidental Keynesian spending that was required to fight WWII. Imagine if we ran up to 120% now but did it on infrastructure spending and alternative energy investment within the United States? Think the economy would recover dramatically and ultimately lower the only ratio that really matters: debt/GDP? Japan has a debt/GDP ratio of over 200% yet the yen has not collapsed to zero. In fact, the Japanese Central Bank recently intervened to halt the rally in the yen but to no avail as the yen/dollar is right back to highs in just under 3 weeks.

Long-term dollar charts misunderstand currencies

The highly circulated charts of the long-term decline in the dollar represent a complete misunderstanding of the nature of currencies. Currencies are not stocks, declines do not occur in isolation; it is a relative game. A long-term look at the dollar must incorporate the incredible growth that has occurred outside the borders of the United States. The United States was an industrial superpower to start last century and then following a worldwide depression emerged the clear victor militarily and economically from WWII. America started as the dominant economy and was the relative winner from the century's greatest military confrontation.

When you're on top and as dominant as America was, the only place to go relatively is down from a currency standpoint for the betterment of yourself. We completely destroyed Japan yet invested heavily to build the country back up into a powerful trading partner. Japan's rise in the last 50 years is not to the detriment of the United States. On the contrary, it's a great boon to America's exporters. Likewise, the success of the euro has resulted in the relative decline in the dollar but that's not a negative. An inter-connected European economy that boasts unencumbered trade with the ease of a single currency is a great plus for global growth. The developing BRIC countries are the world's greatest sources of economic growth currently and do not represent a threat to the United States. While the US may decline in relative standing, how is that bad? Stronger economies and higher standards of livings for other countries will create a better world for all.

In sum, the idea that the Federal Reserve is responsible for the long-term decline in the dollar misses the idea of relativity in currencies and ignores the welcomed rise of major and developing economies around the world. Interest rate policy as an economic stimulus has been used too aggressively in the last couple decades, agreed. We will pay the price for this by inflating away savers' wealth but those mistakes do not imply the complete collapse of our currency. Not by a long shot.

Now for the short euro idea

The trade idea is to short the euro and buy the dollar. The euro has rallied 16% off the June lows against the dollar. Much of this rally has been in response to the concerted actions of the European Central Bank to calm the panic in debt markets we saw this summer. The ECB made the right decisions at seemingly the right time and effectively halted the decline in the euro.

While markets need to go through dislocation and pain needs to be felt to wash out excesses, it also makes sense for governments and central banks to step in to avoid panics and deflationary spirals. Poorly run enterprises need to go bankrupt over time for the system to work but it is not helpful to anyone for otherwise strong and profitable firms to be bankrupted in panics when the government can step in. As a tangent, that sums up why I think the ECB made the right decision. It's kicking the can down the road; that's what these monetary policy decisions are intended to do. Halt deflationary spirals that can wipe out an economy in a short-run panic to subtly inflate in the long-run and spread the pain out into the future by slowly eroding the value of saved capital. This has long been the goal of central banks, to smooth out the business cycle. While we've probably got a few more years of economic malaise, we avoided the intensity of another depression. Better path? You be the judge.

Overall though, I think the United States is a far more innovative economy and should command much greater respect than it currently does from a currency standpoint. The run in the euro has accelerated in September and may be nearing a top soon as the short dollar trade becomes widely accepted as sure money. I do not have this trade on and I'm not sure when I will put it on, if at all. I'm primarily not a currency trader but the high volatility is silly to ignore when opportunities are present. I'll be watching the FXE for a possible trade on the short side sometime soon.

Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Nothing relevant but subject to change.
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