The Dollar Moves Downward
A Question

The Dollar Looks 40% too High, and Long Treasury Yields Look 200 Basis Points too Low

John Fernald and Bharat Trehan worry about the possibility of a recession:

Is a Recession Imminent? (2006-32, 11/24/2006): The sharp slowdown in housing and the inverted yield curve have led to concerns that the odds of a recession have risen.... Our review of the evidence suggests two conclusions: First, recessions appear difficult to predict; second, while the probability of a recession over the next year may now be somewhat elevated, it does not appear to be nearly as high as the yield curve suggests....

The yield curve is perhaps the best known of all the indicator models used to predict recessions.... [A] model developed by Wright (2006) that uses information on the term spread and the funds rate... estimates a 47% probability of recession over the next four quarters....

There is reason to be skeptical about the current high estimate of the probability of recession, because the unusually low rates at the long end of the yield curve are not well understood....

[T]he ability of the yield curve to forecast recessions is often attributed to the fact that the long-term rate reflects market expectations about future developments in the economy. But in that case, one would expect professional forecasters to have this information as well, leading to survey probabilities similar to those from the yield curve. At a minimum, forecasters should be incorporating information from the yield curve into their forecasts...

In my view, there is (some chance of) three things happening as a result of the fact that long-term U.S. Treasury interest rates are nearly 200 basis points lower than historical average patterns suggest they should be:

  1. U.S. short-term interest rates are about to fall by an expected 200 basis points or so--in other words, a recession is about to begin and the Federal Reserve will cut interest rates in response.
  2. Investors today are not nearly as averse to liquidity and price risk associated with holding long-term bonds, and as a result there has been a large permanent decline in the term premium.
  3. Investors believe in (1) or (2) or some chance of each, but they are wrong: there are huge amounts of money left on the table for people willing to short long-term Treasuries, go long short-term Treasuries, and wait for price relationships to return to normal.

Menzie Chinn worries about the possibility of a dollar crash:

Econbrowser: Will the Dollar Plunge? Would that Be So Bad?: One of the enduring oddities of the international economy is the willingness of foreign investors -- both private, official, and quasi-state -- to hold dollar assets despite the very low returns on such assets, even when comparing in common currency terms. It is this anomaly that Krugman disucusses in an academic paper asessening the possibility of a dollar crisis.

Concerns about a dollar crisis can be divided into two questions: Will there be a plunge in the dollar? Will this plunge have nasty macroeconomic consequences? The answer to the first question depends on whether there is investor myopia, a failure to take into account the requirement that the dollar eventually fall enough to stabilize U.S. external debt at a feasible level. Although it's always dangerous to second guess markets, the data do seem to suggest such myopia: it's hard to reconcile the willingness of investors to hold dollar assets with a very small premium in real interest rates with the apparent necessity for fairly rapid dollar decline to contain growing foreign debt.

The various rationales and rationalizations for the U.S. current account deficit that have been advanced in recent years don't seem to help us avoid the conclusion that investors aren't taking the need for future dollar decline into account. So it seems likely that there will be a Wile E. Coyote moment when investors realize that the dollar's value doesn't make sense, and that value plunges.

The presumption that there is investor myopia means that median measures of exchange rate expectations might provide very inaccurate indicators of what will happen in the future. Right now, typical forecasts are for gradual dollar depreciation -- 8 percent over the next twelve months (in log terms) from November 17th, according to DeutscheBank. The USD/EUR rate is forecasted to depreciate by 5.3 percent. In contrast, the Economist reports JP Morgan forecast of zero USD/EUR depreciation over the next year from November 23rd.

Investor myopia might explain -- or at least is consistent with -- the finding that uncovered interest parity (UIP) doesn't hold. Indeed, the failure of UIP is one reason why the "carry trade" is so profitable [see Mike Rosenberg's (Bloomberg) discussion of the long standing nature of carry trade profitability at the end of this chapter]. Of course, in a portfolio balance model common currency returns need not be equalized. But the extent to which the rate of return on USD denominated assets is less than those on other assets is too large to be rationalized by standard portfolio balance models.

On the second question posed, Krugman is much more sanguine. Since balance sheet effects are not relevant (or more accurately, work to the benefit of the US via valuation effects), the dollar decline should have a net positive effect on aggregate demand via expenditure switching. This view is buttressed by the empirical work of Croke et al. (2005) as well as Freund and Warnock (2005).

He is a little less optimistic about avoiding a slump if the current strength of the dollar is due to investor myopia, and housing prices exceed those consistent with rationality and the transversality condition (for instance, if there is a bubble). A downward revision in both the relative market-to-book price (i.e., "q") of housing as well as the value of the dollar might induce a slump if the lags in adjustment to the exchange rate are longer than those to housing prices. My own view is that is likely to be the case.

Indeed, the lags to exchange rate changes are more likely to be longer, the harder it is to move capital and labor to the export sector. After the battering taken by the tradable sector over the past decade, I worry.

And Michele Cavallo worries as well about the carry trade and the failure of uncovered interest parity:

Interest Rates, Carry Trades, and Exchange Rate Movements (2006-31, 11/17/2006): The U.S. dollar has seen some remarkable swings.... Many observers have related these swings to what is known as the carry trade... investors in international financial markets... exploiting the existence of interest rate differentials across countries.

The use of this strategy by investors is puzzling, as the theory of interest parity conditions implies that it should not generate predictable profits.... [A]n investor borrows a given amount in a low-interest-rate currency (the "funding" currency), converts the funds into a high-interest-rate currency (the "target" currency) and lends the resulting amount in the target currency at the higher interest rate....

According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits.... [T]he difference in interest rates between the two countries [should] simply reflects the rate at which investors expect the high-interest-rate currency to depreciate.... In practice, however, investors in international financial markets do seem able to make profits through such strategies. In fact, market participants and commentators have often cited the carry trade as the source of several recent exchange rate swings....

If the carry trade is a risky strategy, why are investors reported to use it extensively? The answer lies in the "forward premium puzzle."... Currencies that ... have a low interest rate... tend, on average, to depreciate, not appreciate.... [C]urrencies that... have a high interest rate, tend, on average, to appreciate, not depreciate....

Burnside et al. find that, for the period from 1977 to 2005, the realized cumulative return to their [carry trade] strategy is very similar to that of investing in the S&P500 index... [with a] the lower volatility of its returns...

The message appears to be that the dollar's value is out-of-whack--too high--because nobody expects it to decline by a lot in the near future, and that expectation means that demand for dollar-denominated securities is high because U.S. interest rates are higher than interest rates in Japan and Europe. One again, it looks like there may well be lots of money left on the table.

A conversation in London:

Trader: We have to take off this short-dollar position. We have no edge in predicting exchange rate movements, and it is costing us 1/2 a percent of the leg every quarter. We need to show good short-term results to keep our investors, and this isn't helping.

At which point the fund's principal says one of two things:

Principal: You are right. Liquidate...


Principal: A, grasshopper. The fact that people like you are coming to people like me telling me that we must take off this short-dollar position is the reason that we must keep the position on...