HardAssetsInvestor

Mike Norman: Hi everybody, and welcome to HardAssetsInvestor.com. I’m Mike Norman, your host. Well, what is the outlook for the U.S. dollar? Many commodity traders, of course, are following the dollar’s trend. We’re going to talk to Mark McCormick today, my guest — currency strategist at Brown Brothers Harriman here in New York to find out. Mark, thanks very much for coming on the program.

Mark McCormick, currency strategist, Brown Brothers Harriman (McCormick): Thank you. Thanks for having me.

Norman: So we’ve had this big sell-off in the dollar, which looks like it's started to reverse a little bit, at least recently.

But the whole thing, this recent thrust-down triggered by QE2, the Fed’s second quantitative easing program — is the dollar’s future looking a little grim to you? Or is this rebound something that may have some legs?

McCormick: Well, there’s a couple of different ways of looking at it. In the lead-up to quantitative easing II, many people that just played the trade were ... nominal interest rates are going down, you have inflation expectations slightly rising a little bit. So you have what economists would call “low real interest rates” actually negative.

And at the peak of the quantitative easing sell on the rumor/or buy on the rumor/sell on the fact trade, negative real interest rates got to about 2 percent. And looking at that — the trade — a lot of people, like myself, like to look at positioning sentiment. We look at futures contracts, look at risk reversals, options, pricing.

Norman: Which has been hugely negative dollar.

McCormick: And that’s the thing. In the run-up to the trade, many people — especially if you look at the macro hedge fund community … if you look at the returns of the euro correlated to the changes in macro hedge fund portfolio returns, there’s a really strong correlation. So all those things line up, and you had major investment, futures investors positioning short dollars. You had major positioning in the option market.

Norman: It was a crowded bet.

McCormick: Crowded trade. A lot of people are getting out of it. They’re taking profits. They’re consolidating. There’s this little hint of risk aversion. You have Ireland on the verge of bankruptcy, or at least accepting aid from the IMF or the EU. You also have a lot of concerns now about China. People are wondering, can China continue to drive the world economy at the rate that they were? And there’s this decoupling notion that emerging markets in East Asia and Asia in general, coupled with Latin America, can they continue to grow as the U.S. gets weaker?

I think a lot of people are concerned that China’s got 4.4 percent inflation, and that China’s actually considering raising interest rates again after they did it a couple of weeks ago.

Norman: The China development strikes me as something new in the fundamental picture, because prior to very recently, China was considered the growth engine. But the European situation … look, we saw this back in May and June, but it was Greece at the time. And the whole thing was calmed down when the ECB stepped in; starting buying bonds. Are we about to move out of this new panic state that we’re in, which is related to Ireland?

McCormick: I think what you’ll get eventually is, you’re going to have resolution for Ireland, perhaps as early as next week. And you’re going to see a lot of people crowd back into the long euro trades. We’re cautioning people about doing that. What you want to do is be selling the euro into those rallies, because currency traders tend to only focus on one thing at a time. And over the summer, people worry about risk on, risk off.

Post-the risk-on, risk-off trade, we had Fed quantitative easing, which is where everyone shorted the dollar. It’s not that people wanted to hold euros; it’s just that most people didn’t want to be in long dollar positions. So they were selling the dollar, basically, fundamentally borrowing dollars like a currency trade, and then investing in higher-yielding assets, and anything that had yield. Because there was a mass search for yield.

With the euro, what you’re seeing here is those problems really never went away. And it’s resurfacing again with Ireland. And the important key point about Ireland is that they’re actually funded until the middle of next year. So it’s not that Ireland has these inherent refinancing costs that they need to go through now. It’s just that people are nervous about Ireland’s government having to bail out the private banks and the private institutions.