The Dollar Index (DXY) is usually considered a trading equivalent of the spot currencies on which it is based. But despite its firmly speculative nature, the index has been no more volatile than its currency components over the past year and in specific cases it has been considerably less so.
The DXY is composed of a basket of five currencies, Euro 57.6%, Yen 13.6%, Sterling 11.9%, Canadian Dollar 9.1%, Swedish Krona 4.2%, and Swiss Franc 3.6%. The index, whose futures trade on the Intercontinental Exchange, was originally created in 1973 by JP Morgan. It components have only been rebalanced once for the inception of the Euro.
Indices are private trading vehicles designed to reflect market interest and to be instruments that traders find useful for speculation. They are designed solely to attract trading enthusiasm; they are not necessarily intended to accurately reflect the economic or financial realities of the currency or its country.
DXY 10 Year Chart (Bloomberg)
The DXY does not mirror the United States trade position in the global economy. It is heavily weighted to Europe, undervalues the Canadian Dollar, ignores South Korea Taiwan and by necessity China. A firm cannot settle a trade flow in the DXY nor is it particularly useful as a hedge because of the specific matrix of its components. But because of these non-economic aspects, an index may conceivably reflect speculative currency opinion more accurately than the underlying currencies. Indices are not directly buffeted by trade flows, subject to investment and capital controls, banking regulation and other rules and regulation impinging on currency speculation except as they affect the constituent components of the index. The speculative urge should dominate the index.
For these reasons the DXY and other instruments like it are thought to reflect overall speculative dollar sentiment without the complicating factors of economics and finance. As example if dollar sentiment is negative then it could be more negative in an index because the makeup of open positioning will only be between the overall positive and negative market sentiment for the currency. From a trader’s point of view, the more an index reflects speculative intent the more volatility it is likely to contain and the more it will move. Movement equals profit, or at least potential profits.
Over the past year dollar sentiment has boomed during the acute crisis phase of the financial crisis, from September to early March for most currencies, and then beat a long retreat as the fear of world economic collapse has ebbed. Is this movement reflected in the volatility of the DXY and does it compare to the shifts in its major components?
During the Dollar positive phase of the crisis, the DXY gained 18% (9/22/08-3/4/09). In the same time frame the US Dollar added 16% versus the Euro (9/22/08 to 3/4/09 and 22% from the 7/15/08 low), 26% against the Sterling (9/18/08 to 1/23/09), 8% against the Swiss Franc (9/22/08-3/12/09), and 27% versus the Canadian Dollar. The American Dollar lost 0.5% % against the Yen from September to early April but gained 16% from its December low to its April 4th high.
The Yen is the exception to the general improvement in the Dollar in this period because its valuation was driven by the precipitous fall in the Yen crosses. The Yen crosses had to reach their nadir which the Euro/Yen did on January 21st before the Dollar could begin to trade higher on its own against the Japanese currency.
Since the index reached its crisis high on March 4th of this year it has lost 16% to Friday’s close. In that same period and from its March high the Dollar lost 19% against the Euro, 23% against the Sterling (from 3/11), 12% versus the Yen, 15% against the Swiss Franc and 19% against the Canadian. The Dollar lost more against each component currency except the Yen and the Swiss that it did in the DXY. From a speculative trading perspective, as least during the Dollar retreat, the components were the place to be.
The peculiar conditions of the financial crisis may have played a large part in this unusual volatility in the real rather than the created currency. The salient fact in the first phase of the crisis was the pursuit of safety by any means. The currency flows during this period were a flood into dollar assets and then in the work out phase an even greater flood out. It seems that when these flows were added to the normal speculative positioning in the currencies they added substantially to the volatility in the real rather than the DXY.
The trading advantage of the currencies over the Dollar Index was most pronounced in the Dollar retreat. Once the reasons for the Dollar ascent in the acute phase of the crisis became clear, and it also became evident that the government rescues would succeed, large speculative interest joined the simple reversal of the pro-Dollar risk aversion trade. These speculative positions were all against the Dollar. Once traders had a chance to assay the situation it became obvious that the abnormal piling into Dollar assets would reverse and the market would join in the rout.
In currency trading the advantage for potential profitability between a derivative and its underlying generally lies with the underlying instrument. For the Dollar Index it is no different. Even during the immense dislocation of the financial crisis the greatest potential for profit was in the spot currencies themselves.
Joseph Trevisani
Thursday, November 26, 2009
Wednesday, November 18, 2009
Market Direction
President Obama’s trip to Asia is one part introduction, one part diplomatic dialogue and eight parts competitive economics. Whatever agreements are met with leaders of Japan, and South Korean or communiqués are issued from the Asia-Pacific Economic Cooperation Conference (APEC) in Singapore, it is the visit to Beijing that matters.
The American President would like China’s cooperation on the Iranian and North Korean nuclear programs, a more flexible currency policy for the yuan, open trade and continued Chinese purchase of American debt. He is likely to obtain only the last, the price for which will be all the others.
China wants unquestioned sovereignty over Tibet, an uncritical acceptance of its internal political and economic policies and reassurance that the United States will honor its debts, rein in deficit spending and prevent a dollar collapse.
The Beijing rulers received assurance on Tibet when Obama refused to see the exiled Tibetan Dali Lama. This administration has not, as in previous terms, harangued China to open its political and economic system. There has been little or no criticism of China from the American political establishment prior to this trip, Treasury Secretary Geithner’s ‘manipulated yuan’ comment before the Senate Finance Committee notwithstanding.
The trade-off will come between the competitive economic agendas of China and the United States. The terms of this agreement have already been set; the China trip simply makes the new status quo plain for all to see.
President Obama will reassure President Hu that Washington takes its debt obligations seriously, that it is about to become serious about controlling Federal spending and that it holds to a strong dollar policy. President Hu will promise not to withdraw Chinese support from the Treasury market. The Chinese will pretend to believe the Americans and the Americans will not press them on any other topic.
The price for China’s continued support of the US debt market and by extension of the administration’s domestic agenda is American acquiescence in all international topics of importance to China. For the Chinese it is an excellent trade, a chance to neuter its greatest international adversary for the price of an investment it would probably have to make anyway. The basic fact of the trade is that China feels it has choices and the United States fears it does not. As long as a Chinese withdrawal from the US debt markets is more frightening to Washington than to Beijing China will have the upper hand in this relationship.
The Chinese currency policy does not just affect its trade with the United States. Because the yuan has been essentially fixed against the dollar since last summer it has depreciated against all other currencies as the dollar has fallen. Terms of trade have worsened for Europe, South Korean, Japan, Taiwan and all of China’s trading partners. Asian central banks have had to spend billions of reserves defending the dollar against their own currencies lest the appreciation become detrimental to their economies. Though the recession has been less severe in Asia it has not skipped over the region. World trade has had a larger percentage drop than the fall in GDP of any individual national economy; the economies that depend most heavily on exports have suffered the most. It does not help that the currency markets have long participated in the positive speculative view of Asian currencies against the dollar.
China’s position as the chief and most important creditor of the United States gives it an influence in the world economy much greater than its relatively fragile political and economic strength warrants. Only the United States has the economic, political and military weight to challenge the Beijing Government’s economic and trade policies. But US opposition is hamstrung by its need to petition the Chinese for more and more money. One cannot ask one’s banker for bigger and bigger loans and then complain about the interest rate.
Beijing’s understanding of the terms of trade that are best for the Chinese economy is encapsulated by its yuan policy. In the long run a currency program that beggars its neighbors does not do China, its trading partners or the world economy any good. After all someone, someplace has to buy Chinese products. Stable economic development for China, as for all others, depends on a domestic economy that absorbs a large portion of the national production. But, at least for the time being China’s rulers have decided that they can obtain a better deal in the global market than the combined opposition of her trading partners led by the United States would have formerly permitted.
President Obama’s visit to Beijing is an acknowledgement of the new status quo in the world economy. China will set the terms of her trade for the world until the United States regains control of its own budget.
Joseph Trevisani
The American President would like China’s cooperation on the Iranian and North Korean nuclear programs, a more flexible currency policy for the yuan, open trade and continued Chinese purchase of American debt. He is likely to obtain only the last, the price for which will be all the others.
China wants unquestioned sovereignty over Tibet, an uncritical acceptance of its internal political and economic policies and reassurance that the United States will honor its debts, rein in deficit spending and prevent a dollar collapse.
The Beijing rulers received assurance on Tibet when Obama refused to see the exiled Tibetan Dali Lama. This administration has not, as in previous terms, harangued China to open its political and economic system. There has been little or no criticism of China from the American political establishment prior to this trip, Treasury Secretary Geithner’s ‘manipulated yuan’ comment before the Senate Finance Committee notwithstanding.
The trade-off will come between the competitive economic agendas of China and the United States. The terms of this agreement have already been set; the China trip simply makes the new status quo plain for all to see.
President Obama will reassure President Hu that Washington takes its debt obligations seriously, that it is about to become serious about controlling Federal spending and that it holds to a strong dollar policy. President Hu will promise not to withdraw Chinese support from the Treasury market. The Chinese will pretend to believe the Americans and the Americans will not press them on any other topic.
The price for China’s continued support of the US debt market and by extension of the administration’s domestic agenda is American acquiescence in all international topics of importance to China. For the Chinese it is an excellent trade, a chance to neuter its greatest international adversary for the price of an investment it would probably have to make anyway. The basic fact of the trade is that China feels it has choices and the United States fears it does not. As long as a Chinese withdrawal from the US debt markets is more frightening to Washington than to Beijing China will have the upper hand in this relationship.
The Chinese currency policy does not just affect its trade with the United States. Because the yuan has been essentially fixed against the dollar since last summer it has depreciated against all other currencies as the dollar has fallen. Terms of trade have worsened for Europe, South Korean, Japan, Taiwan and all of China’s trading partners. Asian central banks have had to spend billions of reserves defending the dollar against their own currencies lest the appreciation become detrimental to their economies. Though the recession has been less severe in Asia it has not skipped over the region. World trade has had a larger percentage drop than the fall in GDP of any individual national economy; the economies that depend most heavily on exports have suffered the most. It does not help that the currency markets have long participated in the positive speculative view of Asian currencies against the dollar.
China’s position as the chief and most important creditor of the United States gives it an influence in the world economy much greater than its relatively fragile political and economic strength warrants. Only the United States has the economic, political and military weight to challenge the Beijing Government’s economic and trade policies. But US opposition is hamstrung by its need to petition the Chinese for more and more money. One cannot ask one’s banker for bigger and bigger loans and then complain about the interest rate.
Beijing’s understanding of the terms of trade that are best for the Chinese economy is encapsulated by its yuan policy. In the long run a currency program that beggars its neighbors does not do China, its trading partners or the world economy any good. After all someone, someplace has to buy Chinese products. Stable economic development for China, as for all others, depends on a domestic economy that absorbs a large portion of the national production. But, at least for the time being China’s rulers have decided that they can obtain a better deal in the global market than the combined opposition of her trading partners led by the United States would have formerly permitted.
President Obama’s visit to Beijing is an acknowledgement of the new status quo in the world economy. China will set the terms of her trade for the world until the United States regains control of its own budget.
Joseph Trevisani
Tuesday, October 13, 2009
Market Direction
The spectacular rise in gold, now hovering in record territory, has been fostered by three very different conceptions: gold as a trader’s choice, gold as a theoretical proof and gold as a historical metaphor.
For the believers in metaphor the ascent of the metal is an augury for the decline of the west; for the theoreticians it is the only secure defense against inflation; for the traders it is a momentum purchase not to be missed. All three groups are buying gold and as yet, none have been proven wrong.
If we translate these speculations into currency terms the traders promise a long position with better returns than any other investment. The theoreticians predict a global currency system ravaged by government inflation and a revolving cast of devalued national scripts. And the third intimates the ultimate end of the dollar as the world reserve currency presumably replaced by the yuan. All three foresee a continued fall in the value of the dollar.
The economic logic of the three groups of gold supporters is currently aligned and all are profiting from the rise in prices. But it would be remarkable if three such disparate scenarios remained in tune for long.
The east may indeed replace the west as the dominant global economic center but it will not do so in time for the ‘metaphorical Spenglerians’ (so named for Oswald Spengler who published The Decline of the West in 1918) to take profit on their investment. Even if true the western decline will be slow and erratic and these position takers will miss their profit levels waiting for the final collapse.
For the theoreticians or monetarists, the second group of ‘gold bugs’, inflation will suddenly spring out of the ground like the product of so many governmental dragons’ teeth. It is inevitable, increase the money supply and inflation follows.
However, with prices in decline in many industrial economies and unemployment at a new and much higher normal, it is hard to see firms extracting higher prices from consumers when cheaper international goods are so readily available. Whatever the theoretical prospect for inflation the current empirical evidence points the other way, toward deflation.
For the third group, the traders, theory and metaphor are irrelevent. The global financial system is under a soothing blanket of liquidity. The central bankers who have warmed the world with cash and who are now (we assume) very aware of the danger of prolonged cheap credit will (we assume), sooner or later, begin to draw back the protecting cover of liquidity. But the reabsorption of liquidity by the banks is wholly conditional on economic recovery. The most forthright of the world’s central bankers, Ben Bernanke of the American Federal Reserve has stated this over and over; there is no reason to doubt his word.
The gold buyers in this group believe the Chairman. Until the central bank begins to tighten credit, excess cash and the pursuit of trading profit determines the price of gold. It does not matter that the bankers say they will tighten credit when the proper time comes, what matters is action. Until the banks actually begin to raise rates and subtract liquidity, for them, gold is a solid buy.
Of the three scenarios the first, the ‘Spenglerian’ is the most impervious to evidence. It exists apart from factual verification or to put it another way, it is always possible to find evidence that the west is declining. It is just a matter of choosing the right statistics. In practical and emotional terms this group will always be long gold, though it is in unsettled times like ours that they do the most buying.
For the monetarists results depend largely on logic and economic equations. If so much liquidity is loosed on financial markets it must over time (duration unspecified) produce inflation. It is a simple monetary equation, a rising pile of cash chasing a much more slowly rising pile of goods and assets. Over time inflation is the end product. But inflation is not solely the product of a balanced equation between cash and goods. Firms must be able to raise prices and consumers must be able to pay those higher prices and those last factors are now very much absent.
Yet economic stagnation and inflation are not mutually exclusive. If returning American economic growth is not sufficient to reduce unemployment what are the chances that the Fed will commence raising rates regardless of the price index? And if on the other side of the world East Asian economic growth takes off and forces commodity and goods prices higher those prices will shortly be felt in the United States. Irrespective of what the US economy is doing the world’s markets can export inflation to the US.
What would prevent the price of oil from climbing as it did last summer if the Chinese, Indian and Brazilian economies accelerate and that third of the world creates its own economic cycle? Will the US be dragged by East Asia into robust recovery? Unknown. But the effect on the overextended American consumer and economy of $100 oil is not unfathomable. There is no certainty that one third of the world economy will be dynamic enough to force prices higher in the US. But if inflation comes in the US it will probably arrive from overseas and US domestic liquidity will have done little to create it.
For the Fed to raise rates and by default defend the dollar US economic growth will have to be robust enough to begin to take down the unemployment rate. This is an entirely unsure prospect.
US consumers are tapped there has been no sign in retails sales or consumer credit that the drivers of US growth have resumed their seats behind the wheel. The effect of a weak dollar on US exports may be pronounced. Shipments may increase enough to substantially reduce the trade deficit. But the US is not an export driven economy nor is its work force widely engaged in manufacturing. Exports may grow appreciably without it having any noticeable effect on American unemployment. Exports might look excellent to economists and free traders without US workers feeling any better or increasing their spending.
Of the three gold buying groups, the monetarists and the traders are most susceptible to Fed policy changes. But the traders are likely to act first. For them the earliest indication of a genuine change in Fed policy will be enough to abandon their long gold positions for profit. Monetarists are likely to wait until they are sure the Fed will act and then wait again until there is proof that the Fed has acted in time to prevent inflation.
And there we have the pernicious effect on the dollar. Until the Federal Reserve reestablishes the link between economic growth and interest rates the logic of the gold buyers is inescapable. Gold is not predicting a decline in the dollar or the inevitable advent of inflation but it is promising that without a vigilant Fed the first will continue and the second creep ever closer.
Joseph Trevisani
For the believers in metaphor the ascent of the metal is an augury for the decline of the west; for the theoreticians it is the only secure defense against inflation; for the traders it is a momentum purchase not to be missed. All three groups are buying gold and as yet, none have been proven wrong.
If we translate these speculations into currency terms the traders promise a long position with better returns than any other investment. The theoreticians predict a global currency system ravaged by government inflation and a revolving cast of devalued national scripts. And the third intimates the ultimate end of the dollar as the world reserve currency presumably replaced by the yuan. All three foresee a continued fall in the value of the dollar.
The economic logic of the three groups of gold supporters is currently aligned and all are profiting from the rise in prices. But it would be remarkable if three such disparate scenarios remained in tune for long.
The east may indeed replace the west as the dominant global economic center but it will not do so in time for the ‘metaphorical Spenglerians’ (so named for Oswald Spengler who published The Decline of the West in 1918) to take profit on their investment. Even if true the western decline will be slow and erratic and these position takers will miss their profit levels waiting for the final collapse.
For the theoreticians or monetarists, the second group of ‘gold bugs’, inflation will suddenly spring out of the ground like the product of so many governmental dragons’ teeth. It is inevitable, increase the money supply and inflation follows.
However, with prices in decline in many industrial economies and unemployment at a new and much higher normal, it is hard to see firms extracting higher prices from consumers when cheaper international goods are so readily available. Whatever the theoretical prospect for inflation the current empirical evidence points the other way, toward deflation.
For the third group, the traders, theory and metaphor are irrelevent. The global financial system is under a soothing blanket of liquidity. The central bankers who have warmed the world with cash and who are now (we assume) very aware of the danger of prolonged cheap credit will (we assume), sooner or later, begin to draw back the protecting cover of liquidity. But the reabsorption of liquidity by the banks is wholly conditional on economic recovery. The most forthright of the world’s central bankers, Ben Bernanke of the American Federal Reserve has stated this over and over; there is no reason to doubt his word.
The gold buyers in this group believe the Chairman. Until the central bank begins to tighten credit, excess cash and the pursuit of trading profit determines the price of gold. It does not matter that the bankers say they will tighten credit when the proper time comes, what matters is action. Until the banks actually begin to raise rates and subtract liquidity, for them, gold is a solid buy.
Of the three scenarios the first, the ‘Spenglerian’ is the most impervious to evidence. It exists apart from factual verification or to put it another way, it is always possible to find evidence that the west is declining. It is just a matter of choosing the right statistics. In practical and emotional terms this group will always be long gold, though it is in unsettled times like ours that they do the most buying.
For the monetarists results depend largely on logic and economic equations. If so much liquidity is loosed on financial markets it must over time (duration unspecified) produce inflation. It is a simple monetary equation, a rising pile of cash chasing a much more slowly rising pile of goods and assets. Over time inflation is the end product. But inflation is not solely the product of a balanced equation between cash and goods. Firms must be able to raise prices and consumers must be able to pay those higher prices and those last factors are now very much absent.
Yet economic stagnation and inflation are not mutually exclusive. If returning American economic growth is not sufficient to reduce unemployment what are the chances that the Fed will commence raising rates regardless of the price index? And if on the other side of the world East Asian economic growth takes off and forces commodity and goods prices higher those prices will shortly be felt in the United States. Irrespective of what the US economy is doing the world’s markets can export inflation to the US.
What would prevent the price of oil from climbing as it did last summer if the Chinese, Indian and Brazilian economies accelerate and that third of the world creates its own economic cycle? Will the US be dragged by East Asia into robust recovery? Unknown. But the effect on the overextended American consumer and economy of $100 oil is not unfathomable. There is no certainty that one third of the world economy will be dynamic enough to force prices higher in the US. But if inflation comes in the US it will probably arrive from overseas and US domestic liquidity will have done little to create it.
For the Fed to raise rates and by default defend the dollar US economic growth will have to be robust enough to begin to take down the unemployment rate. This is an entirely unsure prospect.
US consumers are tapped there has been no sign in retails sales or consumer credit that the drivers of US growth have resumed their seats behind the wheel. The effect of a weak dollar on US exports may be pronounced. Shipments may increase enough to substantially reduce the trade deficit. But the US is not an export driven economy nor is its work force widely engaged in manufacturing. Exports may grow appreciably without it having any noticeable effect on American unemployment. Exports might look excellent to economists and free traders without US workers feeling any better or increasing their spending.
Of the three gold buying groups, the monetarists and the traders are most susceptible to Fed policy changes. But the traders are likely to act first. For them the earliest indication of a genuine change in Fed policy will be enough to abandon their long gold positions for profit. Monetarists are likely to wait until they are sure the Fed will act and then wait again until there is proof that the Fed has acted in time to prevent inflation.
And there we have the pernicious effect on the dollar. Until the Federal Reserve reestablishes the link between economic growth and interest rates the logic of the gold buyers is inescapable. Gold is not predicting a decline in the dollar or the inevitable advent of inflation but it is promising that without a vigilant Fed the first will continue and the second creep ever closer.
Joseph Trevisani
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