Surjit S Bhalla: Go long on the unwinding dollar

IT DOESN'T MATTER

The signs are ominous. The euro is kissing 1.5, the yen is below 108 and a low for the last several years and the pound is persisting above 2. The Fed's broadest measure of the dollar (the 37-country trade- weighted BROAD index) is close to its historical low of 84, reached in Oct 1978, and July 1995. The news gets bleaker still "" oil is at $100 (?) a barrel and commodity producers are planning to change their century-old practice of pricing in dollars. The worst news "" Brazilian super-model Gisele Bundchen has pronounced that she wants to be paid in euros and not in dollars.

Time to go long (buy) the US dollar, at least against the euro, the yen and the pound. This movie is now in the beginning of its third long-term sequel, as made explicit by the graph of the real BROAD index (real in that inflation differentials are incorporated in the index) since 1973. Note the peak in 1985 "" 128.2 (average for the year), and the trough a decade later at 84.2. For currency traders, the high value of the deutsche mark in 1995 was around 1.34 "" today, it has traded close to 1.3 (equivalent to the euro at 1.5). In 1995, leading models, currency experts and even some central banks gave up on the dollar. That was the turning point, as the dollar rallied to peak again at 112 in 2001. Today, we are back to where we started in 1978, and 1995 "" the two previous long-term lows.

The major reason for being long the US dollar is not because of cycles, as indicated in the chart, though cycles are a factor. Nor is it because of sentiment "" the reason being that super models know more about modelling than currency, so when they say the dollar is going down the sentiment is so bearish that the logic of a profitable position is to be contrarian (to the model, all inadvertent puns intended). The major reason for being bullish on the dollar is because of its wildly off value.

Very few people deny that the value of the dollar (or any major currency) must reflect fundamentals, at least in the long run, but not so long that one is dead and gone. Since the level of the dollar in 1980 (1.08 euros, equivalent since the euro came into being in 1999), the US economy has averaged a per capita growth rate of 54 per cent (log cumulative) with cumulative inflation being 78 per cent. For the 12 countries constituting the euro in 1998, the corresponding numbers are 47 and 95 per cent, respectively. Which means that, relative to 1980, the value of the dollar (versus the 12 European economies constituting the euro) based on relative productivity growth alone should be 7 per cent higher; on inflation differentials, the dollar should be around 17 per cent higher. Aggregating, the "fair" long-run value of the US dollar/euro is some 25 per cent higher than the 1980 value. Thus, by these admittedly rough (but ready) calculations, the euro is about 40 per cent above "fair" value today. Similar calculations for Japan yield a "fair" $/yen exchange rate of the yen around 130 to the dollar, or about 20 per cent below the 108 level it is trading today.

As the wide fluctuations in the chart emphasise, there is little reason to believe that the timing of the model is accurate in the short run. But at extremes, this simple exchange rate model has proved very resilient and more than accurate. Couple these fundamentals with the glitter of Gisele, and one has a long US dollar trade as a reasonable no-brainer.

But why has the dollar sunk so far below fair value today? One answer "" China. Everyone realises that the undervaluation of the Chinese yuan was and is a major cause of the dollar imbalance problem of yesterday and today. In order to bring the US current account in line, traders and investors and policy makers felt that the dollar had to come down in value (note the intermediate peak of the dollar in 2001, a value of 112). So it has; but not against the currencies that matter "" primarily China, and some Asian and eastern European economies. The devaluation of the dollar has helped to stabilise, not improve, the US current account imbalance. The Chinese currency continues to reign supreme as the most undervalued currency in the world, even appreciating by some 10 per cent against the Indian rupee in the last year. This undervaluation has shifted the problem from being the US imbalance to the new Europe imbalance as the latter has seen its current account surplus disappear under the weight of the shifting China invasion.

The US dollar is not undervalued against all countries "" obviously. It is vastly overvalued with respect to China, and to a lesser extent, with China's East Asian neighbours who have consistently run a current account surplus, and in many cases an improving surplus. Contrary to many experts in India, the Indian rupee is not in the same undervalued boat as these economies "" India has consistently run a current account deficit and in recent years this deficit has been widening. The dollar will depreciate against East Asia "" so the perfect trade seems to be long the US dollar against the majors and short against China, and East Asia. Any takers?

ssbhalla@gmail.com