Commentary: The Week Everything Changed in USD Land

I remember watching CNBC on September 15 2008, hours after failure of Lehman Brothers.  Markets were panicking and chaos reigned. But looking back in my memory of the jumbled mess of swirling rumors, idle speculation, and fear driven hypotheticals, one image remains burned into my mind's eye.  To this day, I remember the words "US Dollar Sharply Weaker" popping up in the text box above the stock ticker as it cycled through various headlines.  To those of us who have stayed in the market since then, this simple historical fact may come as a shocking revelation.  Indeed, for the better part of four years now, any bad news, inside or outside the US, has been met by investors around the world running to the greenback.  Bad US jobs reports, surging dollar.  Weak German consumer confidence, surging dollar.  China growth concerns, surging dollar.  What is most striking is that even disappointing economic news out of the US seems to be good for the dollar, as market participants assume that a weak US economy means a weak world economy, and they run to the safe haven asset of choice, ironically, the US dollar itself.

However, during the week after the collapse of the once venerable Lehman Brothers, the data shows that people, of all place, ran to the Euro.  Below is a figure of the daily exchange rates for EUR/USD in the two weeks following failure of Lehman.

EUR/USD during the two weeks following the collapse of Lehman Brothers.  The bad news of the failure of a major US firm at first sent the Euro higher versus the greenback as US fundamentals appeared to be the weakest in decades.  The following week however, as the the market digested the depth of the crisis and its global impact, investors raced back into the dollar as a safe haven despite the fact that the crisis had its origins in the US.  The Euro would continue a massive slide all through October and would not find a bottom until April of 2009 at 1.20 USD per EUR. 

The fact that the Euro surged and then fell tells a story that has been slowing unfolding over the past few decades since before the dot-com bubble.  From 1980 until the 2001 recession, the United States had been generally seen as the best opportunity for growth in the world.  All through the 80s and 90s, the dollar rose with domestic equities as the United States was leading what many around the world saw as a secular bull market.  But by the start of the new millennium, the 4.5 percent growth of the nineties was replaced more measured 2.5 percent growth of the early 2000s. For the first time in nearly two decades, the market looked outside the US for the biggest opportunities for growth, and the dollar got hammered.  The biggest beneficiaries were both in vogue emerging markets like Brazil, but also well established economies like Austrailia and Canada.  Both of these countries have seen their dollars push past parity with their American counterpart.  (They crashed during the 2008-09 crisis but have since recovered)

So for that one week after the fall of Lehman, the market had interpreted the failure of the largest US investment bank as just the latest chapter in the overall story of a secular US decline.  Accordingly, major actors continued US divestment.  But as we know now, within a matter of days, investors would be fleeing back into the US dollar as global growth concerns moved to the fore as the crisis deepened.  It wasn't just another failure of a big US firm which was sending signals that the best days for the US were behind it, the entire world financial system was on the brink, and now the amazing story of growth seen in emerging markets was unraveling.  The dollar now traded differently.  Any bad news, US or international, sent it soaring, while even good domestic numbers would cause it to fall as more risk was bought.  In a mere two week span, everthing had changed in USD land.

Today, and as global heads of state, finance ministers, and central bankers continue their quest for growth, the USD stands at a crossroads.  It could continue the trend of trading lower on good news and higher on bad news, as investors seek to continue the pre-2008 emerging bull market which was brought to a screeching halt by the financial crisis.  On the other hand, with the mess in Europe, the US may be poised to lead the world recovery.  In the latter scenario, the dollar would begin to trade higher on good domestic numbers as investors moved into US equities and corporate bonds.  Eventually, the world demand for US debt would rise even more as investors bought T-bills on the speculation that the dollar would appreciate.  If a strong US jobs report ever sends the dollar higher instead of tumbling against emerging market currencies and EUR, it would represent a major shift in the psychology of the market and may be clear indication of a new secular bulls market for both the USD and US equities.

For those of us still interested in emerging market currencies, it may be time to consider switching to a cross rather than buying them against the US dollar.  One idea I have been toying with is switching to the Yen as my funding currency for MXN purchases.  For those of you interested emerging markets like India, South Africa, or Turkey. I would recommend buying ZAR/JPY or TRY/JPY instead of selling USD/ZAR or USD/TRY respectively.  If your broker does not offer these crosses, try buying USD/JPY on dips (I am looking to get long at 79) to hedge against the eventuality of a stronger dollar based on stronger US fundamentals.