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A tutotial on US$...

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REERs and current accounts see USD undervalued vs EUR and JPY
Historically, currency interventions by the G3 countries – US, Europe and Japan –
have followed one key pattern: they were aimed at correcting major misalignments
in real effective exchange rates (REERs). Put simply, intervention supported the
weakest (or fastest depreciating) G3 currency in real trade-weighted terms.
If the G3 mount a concerted intervention today, it would be to support the dollar.
On a REER basis, the USD is undervalued against both EUR and JPY. This is inconsistent
with the improvement in the US current account deficit, and the deterioration in
the current account of Eurozone and Japan.

• The current account deficit in the Eurozone has deteriorated to levels not seen
since 2000. That’s where similarities end. Back then, confidence in the EUR was
so poor that it required concerted G3 interventions to support the single currency.
Today, Eurozone is facing the reverse problem – the EUR is extremely strong on
REER basis. The EZ current account deficit continued to deteriorate into 2009. In the first
five months of this year, the shortfall totalled Eur64.7bn, more than two-thirds
the Eur93.8bn deficit reported for the whole of 2008. The full-year deficit for
2008 was worse than the Eur91.0bn gap seen in 2000.

• Japan reported, for the first time since 1980, a trade deficit for three straight
quarters from 3Q08 to 1Q09. Without the traditional support from trade surpluses,
the JPY should have depreciated sharply. Instead, the JPY appreciated because
of the global crisis forcing JPY-funded carry trades to unwind. Although the
trade deficit reversed back into a surplus in 2Q09, it remains to be seen if they
could return to the high levels seen before the global crisis.

• The US trade deficit, which accounts for more than 90% of its current account
deficit, has narrowed to levels not seen since 2001. This suggests scope for more
recovery in the USD.
** one possible reason why EUR is holding well at this level is the market belief that the Chinese are shifting part of their investment from US$ to EUR as a form of diversification.

The favorite currency for carry trade is the Australian dollar (AUD). Before this
crisis, the AUD’s bounce from its bottom has traditionally followed a modest
appreciation path. The rise we have seen this year is abnormally strong. Based
on its close of 0.8370 on August 7th, AUD/USD is some 17-25% above the 0.67-
0.71 range seen in past rebound cycles.
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  1. MRC & Co's Avatar
    Add in US now has positive interest rate differentials out of all 3.
  2. haunting's Avatar
    Dollar Will Continue to Decline, Yuan May Gain, Strategists Say

    “I look at the euro and I say the worries about the deficit and U.S. debt are mirrored in Europe,” Patterson said. “The euro doesn’t have the same reserve currency support that the dollar has. For a short-term trade, it’s fine. For a long- term diversification tool, I’d stay away from it.”

    “Asia is at a tipping point where you’ll see a transition from export-led growth to domestic-demand growth,” Standard Chartered’s Henderson said. “We’ve already seen the first stage with a huge focus on domestic demand, a huge focus on consumption. The next stage is surely a move away from a cheap currency policy toward stronger trade-weighted currency appreciation in order to dampen consumer costs.”
  3. haunting's Avatar
    As Budget Deficit Grows, So Do Doubts on Dollar

    Now, though, major investors like Berkshire Hathaway Inc. Chairman Warren Buffett and bond investment firm Pimco fear the government's fiscal and monetary stimulus programs could end up fueling inflation in coming years and hammering the dollar. Higher inflation eats up the returns of bond investments that provide a fixed interest income, making them less attractive to investors. Less demand for U.S. bonds could mean a weaker dollar.

    Mr. Buffett, for example, worries that U.S. policy makers will fail to move decisively to curtail the nation's ballooning net debt, expected by some to rise to more than 75% of annual economic output by 2013. Instead, policy makers might tolerate higher inflation, which makes existing debts more manageable but would hurt the U.S.'s creditors, including China and Japan. In this scenario, investors would demand much higher interest when lending to the U.S. government, raising its borrowing costs and making further budget deficits harder to finance at a time when an aging population will sharply boost the costs of social security and government-sponsored health care.
    ** to arrest the fear of inflation, the US govt increases their issuance of TIPS, just so the Chinese can stop worrying about the inflation ginny. This shows how desperate the US needs the foreign buying of their "useless" US$.

    ** in a different tangent, just in case you don't notice this - the US equity market rally, whilst many believe is due to the recovery from recession, but if you were to dig deeper you would have noted this - it was driven inversely by the depreciating US$. In other words, as and when the US$ drop in value, the US$ based assets are becoming cheaper and are attracting more foreign buyers. The cheaper the US$ the higher the US equity index would move. But if you were to discount the index by the corresponding depreciation rates (or if you can work out the real value of the US$), the index would be looking flat line...

    Alternatively, if the US$ were to rebound strongly from the current level, and if this observation holds, then, you should see the US equity taking a tumble. However, a qualification has to be made here - short "termish", this "theory" may not be obvious, just like "trend" and "pattern", you need time and a fair amount of data to confirm this observation.

    (As usual, I could be wrong, so caveat emptor here)
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