Currencies: Dead Cats and Yapping Dogs

by: Ray Hendon August 18, 2008 | about stocks: BZF / DBV / EWZ / FXM / JEM / UDN / UUP    

Ray Hendon

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There are times of crises when the old order appears to fail.  Many cherished relationships and institutions seem upside down: the dollar becomes the peso of the world,  and nations long defined by underachievement and bumbling economies, have taken off with soaring growth and balance of payments surpluses. Models of fiscal discipline and booming exports, countries in Latin America, south east Asia and even Russia’s former vassals in eastern Europe, have become engines of growth.

I frequently read opinions that America of the 21st Century has become Rome of the Fourth, with a crumbling financial system, beset from all sides with barbarians pushing across the borders.  The dollar is down, and it will stay that way, they say.  The end of the old order is at hand!

The recent recovery of the dollar in international markets has given the naysayers a temporary pause, but they remain firm in the belief that this recovery is an illusion—a dead cat bounce, in the vernacular of the trading community.

There has always been a certain amount of yapping in the background of the financial world—the doomsayers will have their say.  Their comments are usually brushed off without much credence.  What makes it different this time, though,  is that the financial instability throughout the world  has discombobulated many investors;  they can’t tell up from down.  None of their cherished principles are holding up, and the volume and certainty one hears so forcibly expostulated gives even the firmest believers in the old order, reason to listen.  After all, with such a dramatic change still pulsing through the world financial system, who can we listen to?  Who can we trust?

I step into this fray reluctantly and without the bravado of certainty that encompasses much of what is said.  I don’t pretend to know when the dollar will peak—it may be days, it may be years.  But I do have an opinion on the subject, and mine is different;  I’m putting my bets on the upside.  The dollar has fallen so far that our goods are now becoming bargains for the rest of the world.  I think the dollar has turned the corner. 

If this proposition is true, then carry traders must adapt.  In my article of last week ("Carrying the Dollar Upstream"), I made this case—suggesting bundles of currencies to help balance a carry trade portfolio, and an orientation to pegged currencies to combat a rising dollar.  I mentioned the paucity of bundled currencies for now, but voiced the belief that more would be coming down the line.

My article was published on August 13th; on the 14th I receive an email from Deutsche Bank that they are now offering a bundle of their own.  This is through their currency trading platform, dbFX, and it was mentioned, not to pump up the product, but as a suggestion of how valuable their research could be to those who use their platform.  Not to argue with their supposition, but to me, the news took on a different cast.  To my knowledge, this is only the second old-line trading platform to offer a prepackaged bundle of currencies with something of a strategy behind it.  And, given the reputation and size of Deutsche Bank, it carries a gravitas that younger and smaller firms lack.

The specifics of their bundle are interesting, and is somewhat in accordance with my own research for suitable trading pairs.  The package consists of six currencies—three long and three short.  The long currencies are the U.S. dollar, the Mexican peso and the Hong Kong dollar.  They  short the Czech koruna, the Chilean peso and the South Korean won.  You can read their press piece here.  They provide a good rationale for their choices.

In the currency trading world they call this a flat carry.  The owner is hopefully left with the interest earned on the pairs, with perhaps a profit on the valuations.  But it is the interest earnings that are its attraction—that’s why they call it the carry trade. 

You can’t duplicate this package with ETFs --not exactly, anyway.  You can go long on the dollar with PowerShares’ Dollar Long ETF (UUP).  And, you can go long with the Mexican peso with their ETF (FXM).  Hong Kong is more difficult.  I don’t know of a single currency ETF or ETN that offers the Hong Kong dollar.  You can get it in a package from Barclays GEMS index (JEM), that I covered last week.  But, you pick up fourteen additional exposures, all long, in the process.

As far as shorting the Chilean peso, the Czech koruna and the South Korean won,  good luck outside a conventional currency trading platform.  These are not widely traded currencies, especially the peso and koruna, so I wouldn’t be looking for them to show up as single currency ETFs in the near future.

But, the Deutsche Bank recommendations still provide value.  Their analysis is, typically, well thought out.  They may be wrong, of course, but I would generally give them the benefit of the doubt on this judgment.

For now, let’s take it as their opinion and look elsewhere for additional information in order to build an optimistic carry trade portfolio.  One suggestion I found is from the head of the PIMCO emerging markets bond fund, Mr. Michael Gomez, Executive VP of PIMCO, portfolio manager and Co-Head of the Emerging Markets portfolio management team.  Mr. Gomez has good practical experience with Goldman Sachs and as a former advisor to the Columbian Minister of Finance and Public Credit.  His specialty is in emerging market bonds, but he must be acutely aware of the currency risks when choosing an EM bond portfolio.  

I must mention that earlier in his commentary Mr. Gomez listed the U.S. dollar as a bad bet, with its terrible balance of payments position and domestic budget deficit.  No one could argue with that take, but in the coming battle for world sales, the U.S. will be competing with other nations that are battling the same demons we face -- high inflation, falling trade and high unemployment-- but they face them with much higher currency prices.  I like our odds.

In his August commentary on the PIMCO website, Mr. Gomez instructs us to:

Concentrate investments in the economies with credible policy anchors and balance sheets strong enough to help them weather the storm. At the top of this list is Brazil, with local bonds a particularly attractive long-run investment. Five-year bond yields are close to 14% in Brazil, with inflation running close to 6%. The Central Bank has cemented its credibility by raising rates aggressively to ensure inflation returns to target. This provides investors a unique opportunity to receive high interest rates in investment grade credit, with credible monetary policy, prudent fiscal policy, solid balance of payments dynamics and political calm (compare this to the U.S. case above). Asian FX (particularly Singapore dollars and Chinese yuan) also offer good risk-reward ratios in this environment, as balance sheets are in many ways the mirror image of the U.S.

Although he is writing primarily about bond investing, the implications for currency holdings are also clear.  He mentions Brazil’s strong position of international reserves, just less than $200 billion in February of this year—see the chart below.

The next chart (click to enlarge) shows the Brazilian real’s  price in U.S. dollars from Jan, 2000, through early 2008.  Note the plummet from early 2000 when the emerging markets financial crises was in its worst throes.  This history is interesting to study.

It developed over a period of years, and almost all emerging nations took it on the chin.  They were all poorly financed, using mostly short term U.S. dollar denominated debt, had poor fiscal policies, and balance of payments deficits.  For Brazil, the beginning of the end came in late 1999 when Russia defaulted on its debt.  That very day international capital flight from Brazil became a torrent.  They were forced to let the real float; you can see the damage.  You can also see how they recovered since then.

In his last sentence Mr. Gomez also recommends the Chinese Yuan and Singapore dollar as having good potential for growth, but I don’t think their interest rates are particularly attractive for U.S. carry trade investors.  The Chinese limit U.S. dollar deposits to around 2% interest.  Singapore is a little better.  They make it easy to open deposit accounts there, but the commercial short-term interest rate is 3.9%.  Not attractive for the carry trade—both  currencies would be strictly value plays.

To summarize the main points,  if you believe that the dollar is turned around, here are some suggestions for structuring a carry trade portfolio:

  • Long on the Mexican Peso (FXM)
  • Long on the Hong Kong dollar
  • Long on the Brazilian real (BZF)

If you are a brave soul, and are willing to go short, the suggestions are: the Czech koruna, the Chilean peso, the South Korean won, the Hungarian forint and the Romanian lei. 

A prudent investor will scrutinize these recommendations with the greatest care and a strong skepticism.  I do not recommend any foreign currency holding for my regular clients.  It is something I do, knowing the risks are high.  But, I am doing it in a carry trade environment (except for UUP), and have no qualms on bailing at the slightest hint of disorder.  If interest rates rise in the U.S., as many expect them to, it may be that within a few years we will again offer an interest rate above inflation.  But, that isn’t the case for now, so I am content to earn higher rates in the currencies I own and take the risks they bring.  These are not buy-and-hold investments.  They are buy-and-watch- closely  investments.  Comfort and international currencies do not go together.

Disclosure: Author holds positions in FXM, BZF, JEM and UUP.

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This article has 9 comments:

  •  
    Aug 18 04:38 PM
    The dollar can't be considered strong just because other currencies are weak . And by the way , Rome ultimately fell because of arragance and greed .Does that sound familiar .
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  •  
    Aug 18 07:08 PM
    Ray,

    That was a well written article. I make a veiled parallel to Rome in seekingalpha.com/artic... but portend that the dollar will indeed rise due to the magnitude of the deflation and risk of collapsing the empire by fiating the loss.
    Reply | Link to Comment
  •  
    Aug 18 09:36 PM
    surgcare: I consider a currency strong if it is going up or at least holding its own against other majors. I consider it weak if it cannot hold its own, as the dollar did not do for the last sever or so years. I feel the dollar is undervalued now, not because of any great fiscal restraint or wisdom coming from our political learers, but simply on the what you get when you pay for something in America with most any other currency. It has been my experience that currencies almost always overshoot the mark and become under or over valued briefly before a correction set in. I think the dollar is there now. But, of course, I may be well off the mark on this estimation.

    As far as Rome, I guess we, and millions of others could discuss the causes of Rome's fall until the end of time. From my limited knowledge of its history, I think Rome was ultimately a moral failure: it never rose above slavery, and it lost the support of the general poplulation over the course of centuries of warfare. In the end, it seems, there was no one left to defend it from more aggressive peoples clammoring to take it.

    Thanks for the comments.

    droskoph, thanks for the compliment. In reading it again, today, I feel I could have said about the same thing with many fewer words, but I almost always feel that way when its over. I wasn't targeting any one in particular about the Rome comments. It's a popular thing to do.

    Best wishes,

    Ray
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  •  
    Aug 18 10:10 PM
    Great article! Thanks for UUP suggestion. I'm not sure peso and real are good ideas though, but they at least worth good research. My hunch, dollar is going up against almost everything. But I just might be wrong...
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  •  
    Aug 19 03:16 AM
    Can we think about the real world for a second. Dollar strength happens to coincide with beginning of games in China. China would build a position before the games to make change!(dollar for dollar) Once games end dollars will be exchanged for Yuan(stored in American fed). This added strength to a dollar which was being bought by world banks to even out of horrible mortgage paper investments in the states. Lastly, there has been a large rise in American exports(backward looking) that is also temporary. Going forward each of these factors are temporary and will not continue in any form to keep this rally going! Until the truth about American inflation is realised dollar is at top of range!
    Reply | Link to Comment
  •  
    Aug 19 10:05 AM
    Greeting Ray,

    Thanks for the ongoing articles about FX carry. It is amazing to see how little info there is out there for such an awesome strategy. You are about the only mainstream writer that details it.

    Also, thanks for alerting us to JEM, not sure how i missed that.

    I think that you will find JEM and DBV have strong correlation in a rising to high volatility market, so i am afraid that i don't share your diversity views with respect to regions and countries. Just compare USD/TRY and NZD/JPY over the last couple years to see what i mean. Many people look at fx carry as a trade with a risk premium because the reversals are so violent. I see FX carry collectively as being either ON or OFF.

    I also do not believe the principle moneymaking of FX carry lies in collecting interest, but then i only employ pairs with a spread >3%.

    Nonetheless, i share your enthusiasm. And look forward to more thoughts.

    Cheers from Osaka,
    john
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  •  
    Aug 19 12:12 PM
    Muddling Investor: You have the right idea to dig into your own research. I am sticking with Mexico and Brazil, but I believe both these currencies may be in for a rough patch ahead. Both countries have slid into trade deficits, and, in my view, Brazil is likely to allow the real to slide vs. the dollar in order to help it correct its deficit. This will probably mean giving up some points of its gain over the last few years. But, I don't think the carry trade investor will lose because the interest rate there is so high.

    elwin45: I must say the economic scenario you lay out is beyond my ability to follow. I don't know what world you are being real about, but it isn't the one I live in. Generally, an increased supply of a currency, such as U.S trourist in China spending for motels, food and taxis, will put downward pressure on their currency--not upward. And, in my world, nations holding bad debt denominated in dollars will not increase their purchases of dollars because of it. I actually don't see much relationship between those two items, other than a tendency to dump the debt and recycle the proceeds into other investments--assuming something is left to recycle. Whether the recycled purchases are in dollars or not will depend on the interest spreads and currency spreads at the time. I'll give you credit for original thinking, but I just don't follow it. Good luck.

    ikkyu: I always enjoy your perspective, and I appreciate your comments. As far as interest being the only attraction of the carry trade, I think you are speaking of motive, which is highly personal, and I am speaking of a strategy. I tend to be somewhat of a purist when dealing with strategies and theories, and try to stay focused on the driving force behind it. But, you are correct that holding currency pairs involves risks, and they may be substantial, in that there is likely to be some appreciation/depreciat... between them. So no carry trader can ignore the prospects of having a profit or loss from the transaction. In fact, if there is a big interest rate differential between two currencies, that is reason enough to expect there to be some change in their currency relationships. The carry trade is a temporary opportunity that requires an exit strategy to be successful.

    As far as JEM and DBV being correlated, that may prove to be true over some time period, but I think that the developed economices and emerging markets do follow a different drummer. So, I don't look for a strong sympathy between them. But, I'll keep an eye on this possibility.

    Best wishes,

    Ray

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  •  
    Aug 19 03:09 PM
    Hi Ray..I'm writing an article on the several ETNs currently distributing dividends and was wondering if there are more than these four that I've found so far- GCE, JEM, PDG and BSR? Thanks for your help. We really appreciate your thorough articles on SeekingAlpha.com.

    We're also wondering if you might be willing to write a contributing editor article on currency ETN/ETF investing for our web-site AboutETFs.com. If so, would you mind calling me to discuss what we're looking for in such an article? We believe an article by you would really be appreciated by our readers (we are a ETF/ETN resource portal for average individual investors seeking unbiased information about ETFs.) We personally have found your articles on currency investing to be pithy, extraordinarily informed pieces! We can even understand (usually) what you're talking about! LOL! Thanks again, Chance Carson, Editor, AboutETFs.com. 719-268-0800. chance@retire101.net
    Reply | Link to Comment
  •  
    Aug 19 03:23 PM
    Oops..I meant PGD not PDG..sorry!
    Reply | Link to Comment
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