However, the past couple of days have erased some of those gains (and in some cases quite dramatically) as the US dollar has strengthened, commodities like sugar, silver, and cotton have come crashing back to earth, and stock markets around the world have shed value, including a 5% one-day drop in the Chinese market.
What is going on here? Well, this article in the Financial Times explains a lot. It’s impossible to know what really moves markets, but this article deftly calls into question the rationale given by people pursuing a dollar-debasement trade and offers reasons to believe that, contrary to popular belief, dollar strength may be in the offing in the near future. Some of the key points are:
1) The bulk of QE2’s effects have already been priced into the market. This isn’t difficult to swallow given that commodities and emerging markets have been on a tear since intentions for QE2 were first announced at the end of August, and the dollar has been weakening steadily ever since. It’s hard to believe that such moves haven't already discounted most, if not all, of QE2’s effects, in which case the immediate post-QE2 rally may have been a blow-off top, the culmination of a “buy the rumor, sell the news” dynamic.
2) The US economy may actually strengthen, which will be positive for the US dollar. Any future strengthening of the US economy – and especially any real improvement in employment – should cause the dollar to strengthen, which would be a drag on commodities (which are priced in dollars) and attract foreign capital into our markets, presumably eroding the premium that foreign markets currently enjoy.
3) Any increase in the use of capital controls by foreign governments will be positive for the US dollar and negative for emerging markets/commodities. This is something we’ve already seen. On Friday, Chinese equities experienced a 5% drop caused by a rumor that the Chinese government is going to have to raise interest rates over the weekend in order to stem the flow of hot money from the US and to dampen its troubling inflation rate. There’s almost no doubt that other countries will soon have to follow suit, tightening their money supply just as the US is loosening theirs. Further use of capital controls by emerging economies was even officially sanctioned during the recent G20 meeting - a not-so-tacit acknowledgment that more capital controls are probably on the way.
Although not mentioned in the FT article, I would add one more reason to be skeptical of the weak-dollar trade post-QE2: the evidence we already have from Japan’s attempts to use the same approach. As this excellent post and this follow-up post detail, Japan’s attempts at quantitative easing earlier in this decade managed neither to weaken the yen nor to strengthen the Japanese stock market. In fact, the opposite occurred; the yen strengthened further against the dollar, and the stock market continued its gruesome slide.
It’s something of a truism that one should never "fight the Fed," but it's also an old Wall Street saw that savvy traders position themselves in the opposite direction from government intervention in currency markets (unless that intervention is extremely aggressive). And, in the case of QE2, which is tantamount to government intervention designed to weaken the dollar (despite Obama’s ridiculous claims to the contrary), one may do well to fade the Fed, so to speak. A stronger dollar may, much to many people’s surprise, be just around the corner.
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