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Reply #15: Morgan Stanley (not Roach) comment: [View All]

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Ghost Dog Donating Member (1000+ posts) Send PM | Profile | Ignore Mon Jan-21-08 08:21 PM
Response to Reply #14
15. Morgan Stanley (not Roach) comment:
Edited on Mon Jan-21-08 08:38 PM by Ghost Dog
The dollars general weakness in the first trading days of the year suggests that investors, collectively, are not yet fearful enough for the Dollar Smile to work. Specifically, this descent in the dollar implies a general presumption that the US being the epicentre of the current global slowdown will suffer the most and that the rest of the world (RoW) will be relatively unhurt from such a slowdown in the US. In addition to this geographical dichotomy, risky assets may need to fall much more for fear to become the main driver of investment. We believe that the Dollar Smile will eventually start to work, when the RoW starts to slow, with a delay.


From yield differentials to the Dollar Smile

The dollar has been weak in the first two weeks of the year. This implies several opinions among investors. First, investors must have the view that the collateral damage from a US slowdown will be ring-fenced and the US will likely suffer the worst of the consequences while the RoW will largely be spared the downdraft in demand. Second, investors may be increasingly discouraged by the low yield premium on USD assets. Our measure of hedging costs for USD-based real money portfolio investors have changed drastically, providing less of a support for the dollar.

However, we believe that both of these opinions will change, allowing the dollar to rally this year against the EUR and the GBP. In turn, the JPY and CHF could rally against the strengthening dollar, for as long as the US is in a recession, which we believe will likely persist through 1H08. One by one, various parts of the RoW will start to show signs of a slowdown/deceleration. Even though we are of the view that this economic re-coupling will be tentative and partial, financial coupling will likely push investors back into fear mode and bond rather than equity flows will, perversely, support the dollar consistent with our Dollar Smile framework.

Back in September 2001, our proxy of hedging costs also breached the 0% threshold. Yet the dollar remained strong until the Bush administration imposed temporary tariffs on steel in February 2002. In our view, this episode in 2001/02 was a demonstration of the safe haven status of the USD. This is related, but distinct, from the discussion on whether the dollar is still the top reserve currency. The fact that three-quarters of all hedge funds worldwide, no matter where they are located, are dollar-based is important, as it suggests that when risk-taking is curtailed in general, the dollar will be bought. We remain comfortable with this view.

On economic and financial de-coupling

A key part of this discussion about the reliability of the Dollar Smile framework is whether the RoW can remain de-coupled from the US, both in economic and financial terms.

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