Global Connections

March 15, 2012

Moving to the Right Side of the Dollar Smile

Bottom line: The correlation between the dollar and risk assets broke down in late-February: while global equities continued to rise and the Fed persisted in calling for QE3, the dollar ceased to depreciate against other currencies. So far this month, the correlation between the dollar and risk has actually turned outright positive: strong U.S. data that fuels risk has actually been accompanied by a strong dollar. The markets reactions to the strong NFPRs and the strong retail sales data in the past few days are good examples. We believe that the currency markets have moved to the right side of the Dollar Smile, due in part to the belated realization that, while the headline growth rate of the global economy for 2012 may not be too different from 2010-11, the composition of growth is very different. Specifically, instead of Asia and EM being the main propellants for the global economy, in 2012, it looks like the U.S. economy will likely be the main engine of global growth. (1) A U.S.-led risk-on phase should be dollar-positive. (2) Continued U.S. economic recovery should make it difficult for the Fed to justify unconditional QE what the doves at the FOMC seemed to have been planning to do. (3) Chinas soft landing will likely lead to more downward pressures on several high-beta currencies, against the dollar. The strongly negative correlation between the dollar and risk assets that has prevailed since 2008 has been evaporating since mid-February. For example, AUDUSD traded in a range of 106.6-108.5 for much of February, before trading through the lower barrier of this range. Similarly, EURUSD has traded lower, after being in a range in February. USDBRL is higher, so is USDTRY. SGD, KRW, and other emerging market currencies have all struggled to rally, despite the risk-on global environment. Further, repeated QE operations conducted by the Fed have artificially depressed the value of the USD. But the USD, nevertheless, has been able to rally in recent days. We suspect we are looking at an important development: the risks to the U.S. economy are biased to the upside, while those to the European and Chinese/EM economies are arguably biased to the downside. In this scenario, a meaningfully large growth gap between the U.S. and its G7 trading partners should, ceteris paribus, lead to outperformance of the dollar, which is still substantially undervalued, in our opinion. The Dollar Smile. In our Dollar Smile framework (please see the chart below), what we have in mind is a definitive move from the left to the right side of the chart. For much of the time during the Great Recession, the left side of the Dollar Smile dominated, with risk aversion supporting the dollar (point A), and an abatement in risk accompanied by dollar weakness as capital is deployed from USD accounts to non-USD assets (point B). However, if the U.S. is to lead the worlds recovery from now on, which we suspect is the case, the U.S. can enjoy such a significant growth premium that more risk-taking could be accompanied by a strong dollar (point C), just as it was in 1999-2000 and 2005.

Year II Issue #84

The aim of Itas Global Connections is to present independent perspectives on economic issues and market forces that affect your current investments and strategies for the future.

USD Value
Fear Mode Greed Mode

B Gutter

Hard landing

Soft take-off

Hard take-off

US Economy

By Stephen L. Jen, Managing Partner at SLJ Macro Partners

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Global Connections March 15, 2012

1) The U.S. economy could outpace other G7 economies; EM economies could slow. We are not making a new point or an observation that is unfamiliar to investors. But the point here is that the dollar is a function of the U.S. growth premium vis--vis other G7 economies. Whenever the U.S. had a big growth lead over other countries, the dollar historically tended to outperform. As the world shifts into a greed mode, the equity market is so deep and liquid that it tends to attract so much risk capital from the world that the dollar tended to rally. At the other extreme, when the U.S. suffered a deep recession, which in turn undermined the rest of the world, the dollar also tended to rally, due to its massive Treasury market. It is when the U.S. grows at a pace that is roughly on par with its G7 partners that the dollar can be influenced more by structural factors (such as the U.S. fiscal deficit, its current account deficit, politics etc.). Thus, at major turning points in the U.S. business cycle, we tend to see cyclical factors dominating structural factors, in dictating where the dollar goes. The Dollar Smile framework we have tries to summarize these conflicting, non-linear, forces in a simple chart. We are in fact at such a turning point, and if the global recovery becomes increasingly dependent on the fate of the U.S. economy, the dollar could rally. 2) The Fed is running out of justifications for unsterilized money printing. QE and QE2 were extremely exceptional monetary policies, from a historical perspective, even though it does not look out of place when most of the G7 central banks are conducting similar strategies. The Feds version of QE, arguably, had the most powerful depressing effect on its currency. The dollar, in our opinion, has been artificially devalued by the Fed. It is this dollar devaluation that has led to considerable angst in Japan, China, Brazil, and other countries, concerning the large capital flows from the US/DM into their economies. This angst has, in turn, resulted in either outright currency interventions (e.g., China), defensive QE policies (e.g., Japan), or capital controls (e.g., Brazil) to temper the appreciating pressures on their currencies. However, as the U.S. labor market improves and with various measures of inflation (core CPI, headline CPI, PCE, ULC) suggesting price pressures remain sticky, despite the still-high unemployment rate, the Fed will have difficulties justifying more money printing through QE3. Sterilized QE has operational constraints, and, if it is implemented instead of QE3, it should in theory not be that negative for the dollar as long as the money injection is sterilized. A cessation in money printing should lead to stabilization in the dollar, and possibly appreciation in the dollar. 3) Other central banks will continue to ease. The Feds effective weak-dollar policy has compelled policy reactions from the BOJ and Brazil. After the Fed suspends QE, it is likely that Japan and Brazil will continue to push their currencies weaker. Similarly, with growth decelerating and inflation abating (somewhat) in other EM economies (China, India, Turkey), their central banks will likely try to ease their monetary stance and engineer weaker currencies. Just as QE2 forced some EM central banks to adopt a defensive monetary tightening stance, and just as the Fed suspends QE, these EM central banks will be in a position to adopt a more dovish stance. The mix of monetary policies in the U.S. and outside the U.S. will likely lead to a stronger dollar. 4) Prospective soft landing in China. China is slowing but will not crash. However, even a soft landing in China may have material effects on the rest of the world. We discussed the mechanisms through which Chinas soft landing could affect the likes of Australia and Brazil both of which have already begun to decelerate. We have two thoughts to add here. First, due to the extreme monetary policies implemented in most DM (developed markets), liquidity has leaked to EM and helped fuel their credit cycles, some of which may be maturing. Chinas mature credit and housing cycles should be seen in this global context, that they are partly the results of extremely easy monetary policies in the U.S. and the de facto RMB peg. Similarly, Brazil is decelerating partly because its credit cycle may be maturing. Our point is that, while DM may be in a multi-year deleveraging process, EM has been in a multi-year leveraging process. We are witnessing signs that the EMs credit cycles may be starting to turn, before the DM countries are able to re-leverage again. Australia could also be included in this discussion. Second, if we consider that the U.S. may continue to recover, while China will decelerate in 2012, AUD should underperform CAD, and BRL should underperform MXN. Bottom line. How the dollar performs with economic growth and risk is not linear. In fact, we found a rather unique convex relationship between the U.S. growth premium and the value of the dollar. No other currency has this convex relationship, since most of the currencies, with the exception of the JPY and CHF, have positive linear relationships with the economic growth rates of the countries in question. This means that, in thinking about the dollar, risk, and economic growth, it is critical to have a view on which side of the Dollar Smile we are on. Recent observations suggest that we may be in the process of moving from the left side to the right side of the Dollar Smile. If this is indeed the case, the dollar will from now on be positively correlated with risk and U.S. growth the opposite of what has been the case for much of the past three years.

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Global Connections March 15, 2012

Stephen Jen is the managing partner at SLJ Macro Partners. Prior to establishing SLJ Macro Partners in April 2011, Stephen was a Managing Director at BlueGold Capital (since May 2009), working as the key risk-taker in currencies and as its macro strategist. Before BlueGold, Stephen was a Managing Director at Morgan Stanley and, from October 1996 to April 2009, held various roles, including the Global Head of Currency Research and the Chief Global Foreign Exchange and Emerging Markets Strategist. Prior to Morgan Stanley, Stephen spent four years as an economist with the International Monetary Fund (IMF) in Washington, D.C., covering economies in Eastern Europe and Asia. In addition, Stephen was actively involved in the design of the IMFs framework for providing debt relief to highly indebted countries. Stephen holds a PhD in Economics from the Massachusetts Institute of Technology, with concentrations in International Economics and Monetary Economics. He also earned a BSc in Electrical Engineering (summa cum laude) from the University of California at Irvine. Stephen was born in Taipei, Taiwan, and now lives in London with his wife and two children.

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Global Connections March 15, 2012

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SO PAULO Ita Corretora de Valores S.A Av. Brigadeiro Faria Lima, 3400 - 10 Andar So Paulo, SP, Brazil, 04538-132 HONG KONG Itau Asia Securities Limited
Regulated by the Securities and Futures Commission in Hong Kong

NEW YORK Itau BBA USA Securities Inc. 767 Fifth Avenue, 50th Floor New York, NY 10153 TOKYO Itau Asia Securities Limited Tokyo Branch NBF Hibiya Bldg. 12F 1-1-7 Uchisaiwai-cho, Chiyoda-ku Tokyo, 100-0011, Japan

LONDON Itau BBA UK Securities Limited The Broadgate Tower 20th Floor - 20 Primrose Street London EC2A 2EW DUBAI Itau Middle East Limited

29/F, Two International Finance Centre 8 Finance Street - Central, Hong Kong

Al Fattan Currency House (DIFC) 3rd floor room 305 (P.O. Box: 65703)
Dubai, United Arab Emirates

Itas Complaints Officer (Ouvidoria Corporativa Ita) may be contacted at 0800 570 0011 (calls from Brazil), on business days, from 9 a.m. to 6 p.m. (So Paulo, Brazil time) or P.O. BOX 67.600, Zip Code 03162-971. The information herein is believed to be reliable but Ita Corretora de Valores S.A. does not warrant its completeness or accuracy. Opinions and estimates constitute our judgment and are subject to change without notice. Banco Ita S.A. may have a position from time to time. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for purchase or sale of any financial instrument. This report is prepared by Ita Corretora de Valores S.A. and distributed in the United States by Itau BBA USA Securities, Inc., and Itau BBA USA Securities, Inc. accepts responsibility for its contents accordingly. Any US persons receiving this research and wishing to effect transactions in any security discussed herein should do so only with Itau BBA USA Securities, Inc. Analysts who are not CNPI only provide the team with technical support, not issuing personal opinions.