If it makes it as a publication cover, the move is over

There is the old adage that if an investment story makes it as a cover of a business publication its trend is over. Well, the Economist came out with its cover for the week highlighting the panic of the dollar. What happened today in the currency markets? We had the strongest dollar rally in the last two days since the beginning of the credit crisis. While I still may not be convinced that the cover story adage is worth committing capital, markets do move to extremes and see rebounds. After a strong month, this may have been the time for a small dollar rally.

Surprisingly, the dollar rally has come at the same time as the US economic news has been poor and the Fed has been telegraphing another rate cut. One would expect that the dollar would further decline on the expected further decline of US interest rates but other factors seem to be in play. The dollar rally has been matched by a significant sell-off in crude oil. Crude and the dollar have seen a negative correlation in 2007, so an almost $10 per barrel decline may be the best tonic for an anemic dollar.

Carry trades and volatility –

Carry trades have declined with the increase in interest rate volatility. This relationship is actually predicted when tests of unbiased forward rates are adjusted for changes in volatility. One of the empirical relationships which have driven carry trades is the fact that the forward rate is a biased predictor of future spot rates. Given the strong evidence of this bias, there is a strong level of confidence with the doing carry-type trades. However, recent research from the Koopmans Research Institute suggests that the results that reject uncovered interest rate parity are themselves biased by the differences in volatility of interest rates.

http://www.uu.nl/uupublish/content-cln/06-162.pdf

The result of the research by Hadzi-Vaskov and Kool show that uncovered interest rate parity cannot be rejected during those periods when the anchor interest rate is highly volatile. This could simply be a result of the estimation procedures used but previous researchers, but I would suggest that it is also related to the fact that investors do not want to undertake carry trades during periods of high volatility. The risk from holding carry trades is higher so there is less pressure pushing rates away from uncovered interest rate parity.

Currency overshooting and the overvalued dollar

Currency overshooting was a key area for policy discussions and research concern in the 1970’s and 80’s by government officials and academics. The concern especially in the 1980’s was the significant overvaluation of the dollar in the mid-1980’s. These wide deviations from fair value were the main reasons for the Plaza and Louvre Accord for coordinated central bank intervention. It was believed that the deviations could not be solved without coordinated activity. The talk of overvaluation of the dollar and coordination is again evident.

The figure from Bank of America shows the size of deviations from fair value for the dollar relative to a basket of developed countries. There has been a significant change from overvaluation in 2000 to the current undervaluation. The Bank of America data does not show the dollar to be at all time extremes; however, it has levels which suggest that a revision is much more likely. Nevertheless, one of the problems with finding the fair value of any currency is that there is no consensus on what is fair value. Most banks will use multiple models to determine the deviation from fair value, so, at best, we can say there is a tendency for movement from equilibrium but we cannot say the amount of deviation with any precision.

We can see why there has been a recent strong dollar decline by using a classic overshooting model. The most widely used model of currency overshooting is based on the idea that exchange rates see more volatility as a response to some monetary shock because prices for good are relatively sticky. For markets to clear, there has to be an over-reaction in exchange rates. Some of the recent move down in the dollar is consistent with the Dornbusch sticky-price overshooting model. The Fed has increased money in response to the credit crisis. This monetary shock, it really was not expected before the credit problems of August, caused short-term rates to decline and led to a depreciation of the dollar. We can see that real rates have declined relative to the rest of the world and the dollar depreciation matched the change in real interest differentials. While these links are not perfect, the recent dollar decline should not be overly surprising.

Fixed income sending bad news signal

Market prices convey signals on what investors are thinking. In the bond market, fixed income traders are not happy. Look at money markets. Short-term LIBOR rates shot up during the credit crisis in August but moved down after action taken by the Fed and a general perception on the limited extent of the crisis. However, credit crisis uncertainty has not abated. The crisis has lead to continued write-downs of CBO’s and a lack of liquidity in the commercial paper market. LIBOR rates are again on the march upward. The spread between Fed funds and LIBOR has actually increased and now moving back to the highest levels since August. Now it is natural that the spread will increase after a Fed action. LIBOR will usually follow Fed funds and not lead the rate, but currently, short-term LIBOR spreads are moving higher on growing credit risk. There seems to be special concern about the year-end turn.

The Treasury curve is signally a significant slowdown in growth. The curve changes have not been driven just in the front-end but have been a general parallel shift down in rates. Treasury yields are actually lower than Fed funds across the board which is out of the ordinary. By this standard, the Fed is actually tight with monetary policy. Put another way, the fixed income markets have a significantly less rosy picture on the economy than anything that is being forecasted at the Fed. We know that the Fed has a relatively rosy picture because their latest forecast as part of the new transparency does not show any recession but just growth below trend for the next two years.

The Fed has responded with a temporary injection of funds of approximately $8 billion which is similar to recent action taken. The objective is to ensure liquidity through the end of the year. Year-end volatility may be especially large this year because of clean-ups of the balance sheet. More Fed action will be needed to alleviate fears in the fixed income market.