Dollar Bill

One of the things I do to test my conviction on my views is to reverse engineer outcomes on trades. My last big success on this was asking, back in mid-January, if we’re in May, and the S&P is 15% higher, what would have to have happened? The conditions actually seemed more likely than not – so I made the bet. Reverse engineering outcomes is something Charlie Munger and Richard Heur – whose books are listed next to this post – argue is essential before committing to any view.

In late March, I tried the same thing on the US dollar. If the US dollar was up 15% by the end of the year – what would have made it happen? Problem was I couldn’t answer the question well enough. So I didn’t trade.

Most likely, we were due a correction. Sentiment against the dollar was extreme. There was a raft of business magazine covers depicting the dollar crash – notably the Economist’s George Washington going down in a fighter plane late last year. And this kind of sentiment usually coincides with a low.
And then there was a macro kicker. The US tax-break was going to be a monster – pretty much guaranteeing above trend US growth through the middle of the year. But Europe was on its uppers – leading indicators were deteriorating rapidly, and the hard numbers were likely to follow suite.

That, I thought, was good for 5%. But, by the Autumn the US would be slowing again and the Fed likely considering cutting rates - so I couldn’t think of anything too likely to get me to 15%. But I’ve had another go – and now I can.

First off, the valuation on the Euro isn’t exactly compelling. At my previous house, we recreated a bunch of Morgan Stanley currency strategist Stephen Jen’s models – which are showing the dollar at a two standard deviation extreme in cheapness against Sterling and the Euro. That the dollar is cheap, and the Euro expensive, I think, everybody knows.

But what I hadn’t realised – and thanks to Chad Slater for this one – is that it now costs the same to buy a Big Mac in Shanghai as it does in New York. Now I’ve been listening to folks banging on for so long about why the Renminbi needs to be revalued, that I’d stopped testing the assumption that it is cheap. It isn’t.

So what’s happened in China? In one word; inflation. China has seen its inflation pick up sharply. But the degree of increase is masked in the official CPI, due to statistical manipulation, and due to price controls. Go to something that isn’t controlled – like a Big Mac – and you get a better picture. And China’s inflation is not just food. Chinese wages are booming – with 15% pay rises a regular occurrence in the Pearl River Delta and other Industrial hubs. And employer costs are rising even faster than this – as they have to compete with other employers by providing bed and board for increasingly scarce migrant workers. The result is that productivity can’t keep up, so unit labour costs are rising at 2-3% annually, compared to an average 2-3% fall just five years ago. China has revalued by another means – by letting inflation build, it has reduced the value of it’s currency while allowing it’s currency to appreciate gradually against the dollar.

But I don’t see China as the problem. Yesterday I put the emerging markets into boxes. China was a ‘conservative reflator’ – pretty stable in my book. What’s interesting to look at is the wild ones. I described a wild inflator as a country with big dollar earnings from dollar exports, plus booming credit growth (of more than 3x GDP growth). Russia and many of the Gulf States fall into this category. Now the Gulf States are dollar peggers. But they’ve got inflation running in the teens. So they’re already appreciating by 10+% against the dollar – just by keeping the peg. I don’t think the revaluation of the gulf currencies is the slam dunk that many believe it is. The currencies are getting less valuable by the day.

But it’s when you look at the wild reflators – the countries that have seen large capital inflows into their bond and property markets, combined with blow-out current account deficits and booming credit expansion – well, then things really heat up. Because their fair value against the dollar is collapsing. The Ukraine, Latvia, Vietnam etc – it’s a long list. Soon, they’ll be the wild deflators.

And what I think we’ve got here is the start of a story. The potential for a self-reinforcing trend to emerge – involving capital flight, bank write offs, reduced willingness and ability to lend, weakening currency, falling asset prices (especially in foreign currency terms)and more capital flight. And what’s interesting about this is the potential for the infection to spread from the wild reflators like Eastern Europe and the Baltic States – to a mild reflator like Europe. Why?

The first reason is the Euro area contains within it some wild reflators. Spain, Ireland and Greece are the obvious contenders. But Italy – while it hasn’t seen that degree of credit expansion – is getting there on the deficit front. Spain and Ireland are already seeing reflation twist into asset price deflation. Soon this will spread.

The second reason is that the European banks were best in class when it came to funding the wild reflators. Yesterday I talked about hedge funds running a leveraged long equities trade with a trailing stop for 61 of the last 62 months. Well, that’s chicken feed compared to what the European banks have been up to. For a decade they built up assets in the wild reflator states. It is the essence of the convergence trade – betting that bonds, currencies and property values in the periphery will converge with those in Germany and France.

Now that trade is beginning to unravel, the European banks have started to realise that there is no one to sell their positions to. They are all sellers. And they are all very large in the trade.

A risk study I read on the Amaranth hedge fund blow up said that a priori, based on a VAR analysis, it was a 12 sigma event. It should have only taken place once in around 100 lifetimes of the universe. Unlucky, then.

The study was a bit better than that though. It highlighted that Amaranth got too large in the forward natural gas market, and that there was no natural buyer. So Amaranth changed the blow-up odds against itself. From around 12 sigma to around zero sigma.

In my view, that is exactly what the European banks have done. Their risk models say one thing about their convergence trades. But the fact that they have all got on the trade, and all got on it large, has completely changed the odds.

As with housing in the US. When people said, at the start of 2007, that US housing had never fallen in nominal terms, and that was a reason for not being bearish, it was, well, a poor reason. Because the banks, the subprime borrowers and the buy-to-letters had changed the odds of the game.

And so that brings me back to the currency call. From a point of extreme valuation against the dollar, I can now see a process whereby the Euro, Sterling, the Swedish kroner, and the Eastern European and Baltic currencies now fall into a self perpetuating spiral of devaluation and debt deflation.

Yesterday, I put on some dollar longs.