Friday, 21 September 2007

The Dollar and the fans of Wile E. Coyote

Paul Krugman uses the term 'Wile E. Coyote' moment for when traders find a currency level is unsupported by fundamentals and it drops precipitously. Certainly some currencies display very fat tails: they tend to have long periods of stability, followed by one or more greater than five s.d. moves. (The interested reader may at this point wish to fit the Generalised Pareto Distribution to twenty or more years worth of dollar/yen returns, and compare the GPD VAR with the normal one at 99.99%: typically it's very roughly four times higher.)

Krugman further suggests that a Wile E. Coyote moment may be approaching for the dollar. This is more than just suggesting that the dollar will fall: the fall has to be steep to qualify. Tanta over on Calculated Risk has some supporting evidence (which is a little glib but bear with me):

Bear in mind that the principal channel through which Fed policy affects domestic demand is via housing. If a burst housing bubble is part of the economic problem, the Fed’s leverage over the economy will be greatly reduced, and even a zero Fed funds rate might have only modest stimulative effect.

The problem is too many people are talking about this possibility: many currency strategists expect dollar weakening, so existing dollar shorts will tend to make large falls much less likely. The macroeconomic picture is not encouraging for the dollar, it's true. As Long or Short Capital put it, albeit amusingly bluntly:

I challenge you to find one measure of wealth OTHER THAN THE DOLLAR which shows the US economy as worth more now than in 2001. If I wanted to buy our country it would cost me 30% fewer euros today than it did in 2001, it would cost me less bars of gold, less barrels of oil, less ounces of copper, less btu’s of natural gas, less cubic feet of lumber, less of almost anything that has intrinsic value. Yet you keep reporting GDP growth, why? Because your quick fix is to effectively print more money so that in dollar units everything is getting more “valuable”. But guess what, to the 95% of the world that doesn’t use dollars the true value of the US economy has been shrinking, rapidly.

Moreover, central banks, notably asian central banks, are not buying enough dollars to provide a floor. As Brad Setser says:

The world’s key central banks have concluded that they have more reserves than they need, and are rapidly losing interest in adding to their dollar reserves. China’s central bank has made it known that it thinks it has enough reserves. Some in China think the PBoC already has far more reserves than it needs. Korea’s central bank has indicated -- at various points in time -- that it has more than enough salted away. The ADB agrees.

Still, currencies are often a long way from macro-economic equilibrium, and the U.S. has historically shown an astonishing ability to grow out of difficulties. Despite the fundamentals then instinct suggests that while one might not want to be short dollars yet. That just leaves buying the potential to benefit from a Wile E. moment via the options market. Perhaps selling short term downside gamma (in the belief that Wile E. will take a while to arrive at the cliff) generating cash to pay for a longer-dated further from the money position might be interesting.

I'm sure a salesperson will soon christen this 'the Coyote trade': look for a range of North American mammal structured notes at your friendly investment bank shortly.

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