Today's comment is by Jack Crooks, Currency Director for The Sovereign Society, and Editor of Crooks on Currencies.
Dear A-Letter Reader:
The "dollar smile" is a concept developed by Morgan Stanley economist Stephen Jen. It highlights the three major scenarios that could determine if the U.S. dollar will go up or down, as we head into 2007.
1) The left side of the smile reflects an appreciating U.S. dollar if global risk comes back into the financial system. Despite the ongoing problems facing the U.S. economy and the much talked about structural problems that are supposed to hurt the dollar, e.g. budget deficit, trade deficit, etc. the dollar could rally significantly if there's a shakeup to the global financial system. And there is a scenario unfolding that could do just that.
You see, U.S. fund managers hold approximately US$18 trillion in their hedge funds, which help prop up the U.S. dollar. These amounts dwarf the foreign exchange reserves held by Asian central banks. And I suspect much of this US$18 trillion investment is highly leveraged on borrowed money, based on the latest data from the Bank of International Settlements and International Swaps and Derivative Association.
Leveraged bets by institutional fund managers have been successful thus far because there's been little volatility in financial markets and because stocks and bonds have continued to trend higher and higher on this wall of money.
But this game, or a large portion of it, could end quickly if there is a major institutional bankruptcy or political shock. Given the general level of euphoria across the global stock and bond markets, this type of surprise could easily trigger a rush back into short-term U.S. deposits for safe-keeping. That would spark a significant rally in the buck no matter what the condition of the U.S. economy is.
2) The middle of the smile reflects a depreciating dollar against the major currencies as the U.S. economy continues to muddle through . This view takes into account the ongoing weakness in the U.S. economy led by U.S. consumers finally surrendering to falling housing prices, rising energy prices, and too much debt. This would shift the expectation among currency players from a Federal Reserve Bank that is virtually "on hold" to one that is looking to cut rates as fast and as often as it can going forward. This could be a double-whammy for the buck. If growth falls and interest rates fall, then the buck loses the two fundamental supports to keep it afloat against the major currencies. It would be the green light traders need to dump dollars. And with overall sentiment in the market still being dollar bearish, this would validate expectations and likely lead to more and more selling.
3) The right side of the smile reflects an appreciation in the dollar on the back of a U.S. growth surprise . Even though U.S. consumers have taken a hit from the falling housing market, consumers have overall, shown surprising resiliency. Just a few months ago, many economists expected that the surge in energy prices -coupled with the downturn in housing and rising interest rates - would hammer consumer spending and push the U.S. economy to the edge of recession.
There is no doubt all these factors have slowed U.S. growth. And housing is still the major wildcard that could push the consumer over the edge. But, some economists are beginning to believe that if the U.S. job market remains firm, U.S consumer spending and growth could reaccelerate. This rather optimistic crowd is labeling the current economic slowdown a "mid-cycle pause." That would surprise the market and it would shift current expectations toward higher U.S. economic growth and higher U.S. interest rates. And that's good news for the buck.
Only time will tell which of these scenarios plays out. I'll be on the lookout for any indicator that favors one scenario over the other. But rest assured, no matter which direction the dollar is headed, I'll tell you how to play it. Stay tuned.
JACK CROOKS, Currency Director
On behalf of The Sovereign Society
www.crooksoncurrencies.com
EDITOR'S NOTE: Jack Crooks gave a popular presentation on the U.S. dollar in Puerto Vallarta, Mexico earlier this month. And now you can listen in to his best ideas, for not just the U.S. dollar, but all major currencies, as we head into 2007.
Click here to learn more:
https://www.sovereignsociety.com/catalog/product_info.php?products_id=58
