Wednesday, October 19, 2011

U.S. Dollar and Euro - Review and Outlook

Axel Merk & Kieran Osborne, CFA, Merk Funds have just published their outlook for the US dollar, the Euro, the Chinese RMB and several other currencies.

They have a bearish view on the US dollar:
Policy makers in Washington didn’t help appease market concerns: leaving the decision to raise the Government’s debt ceiling to the last minute only exacerbated market fears of a U.S. default and further degraded investor’s view of policy makers; ...Standard & Poors subsequently downgraded the credit rating of the U.S. government, citing the inability of the political leadership to come together and agree on a plan to sustainably rein in the deficit over the long term as a key reason for downgrade. We consider these developments have further eroded the safe haven and reserve currency status the U.S. dollar has held for so long, and continue to view the outlook for the U.S. dollar negatively over the medium to long term.
minutes from the FOMC meeting show there was support for further expansionary monetary policy, or quantitative easing, which would constitute “QE3”. It is our assessment that the likelihood of the Fed instigating QE3 has risen significantly, in part due to the weakening economic outlook, but also because of the composition of voting members next year. All three dissenting voices will be replaced in 2012 and the average monetary policy stance of voting members will become much more dovish (only one voting member is considered a hawk – Jeffrey Lacker, the Richmond President)1. With inflation expectations declining, we consider Fed Chairman Bernanke may again present the need for further easing, arguing deflationary risks have become elevated, or at the very least, that further easing will not generate significant inflationary pressures. We believe the impending FOMC composition may consider this argument compelling, and is likely to err on the side of overstimulation. All of which leads us to believe that the outlook for the U.S. dollar remains to the downside.
even if in the short term there are risk, they are bullish on the Euro in the medium to long term:
Europe certainly has problems, but in an odd way, it is the inflexibility of its political make-up that may lead to a stronger euro over the foreseeable future. ...
Many individual countries find themselves with very weak political leadership, but interestingly, have instigated, in many cases, very strict austerity measures with opposition support. The issues facing the Eurozone are significant, and there is no simple, easy solution; it’s likely to be a drawn out process rectifying years of malinvestment brought about by unconscionably low funding rates for periphery nations (Greece could borrow at rates similar to Germany for years leading up to the crisis). In turn, economic growth may be restrained over the foreseeable future. Note, however, that economic growth is not necessarily a precondition for a strong currency; it is not incompatible to have poor economic growth on the back of a strong currency – just look at Japan.
We believe two key reasons have contributed to Japanese yen strength – weak leadership and a current account surplus.
On the above two factors, the Eurozone is not so dissimilar to Japan: the Eurozone has a broadly balanced current account, fiscal union is disjointed at best, and many individual nations have very weak political leadership. Furthermore, the ECB has a sole mandate of price stability, and is reticent to provide any direct bailout funding or directed asset purchases to the financial industry, or specific sovereigns, for fear of overstepping its bounds (or being taken to court by the Germans).
As a result, we consider the euro can appreciate on the backdrop of weaker economic growth and continued divergence in monetary policies
Finally, they mention they still have a positive view of the Chinese Yuan:
We continue to see upside potential in the Chinese renminbi and believe policy makers will continue to be incentivized to allow the currency to appreciate to tackle domestic inflationary pressures.

The full outlook is available at

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