As from one Englander to another, so from one massive dollar short to another, we next shift to Steven Englander of BarCap and his daily "Dear USD" hate mail. The man who has been obsessively telling his clients to sell dollars as if he was a subsidiary of Goldman Sachs, must have booked some serious L on the recent, and very much expected, dramatic dollar retracement over the past 3 weeks. In his latest "FX for paranoids and hopeless romantics" Englander does point out one relevant item: that the Fed needs EM countries to keep selling the dollar in order to i) keep commodity prices higher, thereby benefitting these very EMs, and ii) to keep commodity price inflation high, in the absence of other forms thereof (wage, non-commodity price, etc). And that is why, Englander hopes and prays, both for his book, and for those of his clients, that Bernanke will keep on talking big all the while printing more and more dollars as ever more wealth is channeled from the middle class to both Wall Street and abroad.
The report is interesting in that for once Englander, having been discredited by the recent dollar rally, allows for the possibility that the dollar is not a one way train to Hades. For the first time, he discussed the possibility of a eurozone country (Greece) defaulting but staying in the euro - a situtation in which you do not want to be long EUR.
The problems facing Greece have brought the infrastructure of the euro area into focus, as we discuss in “Eventually all chickens come home to roost.” The spirit of the Maastricht Treaty’s “no bailout” provision suggests that this is the tough love that is supposed to be an integral part of the euro, However, few investors believe this is a likely outcome. The collateral damage on the bond markets of the countries seen as having similar difficulties is likely to be immense. Even speculation on this score is likely to lead to significant EUR weakness, as most investors take the view that a bailout of some sort is the most likely outcome (although that certainly does not preclude some tough love, as any parent will be familiar with).
However, even if the tough love provisions were followed, the EUR would not be in the clear. Countries with difficult fiscal situations that did not default could find themselves with pre-
ERM interest rate differentials and post-ERM exchange rate inflexibility. In these circumstances, often an accompanying devaluation helps since it opens some upside to the fiscal offender’s currency and the appreciation risk can take some pressure of rates, but this would not be possible in the EUR world.
The incentives are immensely in favor of fiscal consolidation, tough love, and some exceptional aid, and these would be EUR negative, even in the absence of a default (which we do not expect by any means [TD: no way]), but the FX consequences of a default would be an order of magnitude greater, even if it were thought that the default could be accomplished without an exit from the euro area.
So with that proper Cramerian hedge (being right no matter what happens sure must be nice), the usual DXY bashing ensuses:
Central banks have been disciplined so far in limiting their USD selling. In Q2 the IMF COFER data showed that the USD represented less than 40% of incremental reserve accumulation, but there is little sign that reserve managers are selling enough USD to drive down the USD share in reserve portfolios significantly. Almost all of the drop in the USD share in reserve portfolios over the last 7-8 years has come from valuation effects rather than direct USD selling.
The question is whether this discipline will continue to hold. At present, it does not appear that any major reserve manager wants to be responsible for creating a run on the USD by selling hand over fist. However, while no central bank wants to be the first to sell, no central bank wants to be the last either, so the risk is that if it becomes clear that there is significant official selling, other reserve managers will follow. Putting the two together, there is a potential “bank run” problem. If reserve managers lose confidence in USD strength there is a first-mover advantage in selling it. All know this and it could easily lead to a period of USD strength followed by a sharp fall as people run for the door.
This and the previous item point in opposite directions. The difference is that USD selling can be precipitated by a single reserve manager selling significant USD out of its portfolio, whereas the first risk requires some degree of coordination across central banks.