The Dollar is King, from Ed Tal

December 15, 2006 |

There is little doubt that the dollar has declined in real terms over the last 25 years. In 1980, a $100 bucks would buy you over 20,000 yen. Today, your $100 gets you a little less than 12,000 yen. That’s about a 40% decline. Sounds huge right? Well if you think about, the dollar has only depreciated 1.6% per year, on average. That sounds a lot different doesn’t it? Right now, the Yen is trading at -516 forward points to the dollar. That means the market is already priced for a 4.36% dollar decline against the yen over the next year. I don’t know if that makes sense or not but it easily explains why Japanese investors aggressively export capital and buy US Treasuries en masse. The coupon available on US Treasuries easily exceeds the implied depreciation of the dollar. Based upon the dollar’s track record against the Yen since 1980, it’s unlikely to move down by more than 4% in any single year period. There is an obvious trade here.

Based upon my own empirical observations, it is very difficult to join all the doomsayers on the dollar. The dollar is unbelievably sticky. Cab drivers in Malaysia, Th##land and Bali all ask for dollars. They will take the local currency but they prefer dollars. Same in Eastern Europe. They don’t ask for Euros, they want dollars. More telling is the way trader performance and risk is measured in non US banks. No one says “Hey Pierre, how many Euros did you make today?” Or “Lee, what’s the pv01 of that trade in Korean won?” The dollar is the King at the low end (cabbies) and at the high end (finance). It will take a very long time to dethrone.

Steve Ellison adds:

The market may be more efficient than you think. Forward pricing of currency contracts depends on the difference between the risk-free rates available in the two countries. Japan still has very low interest rates. 4.36% seems very much in the ballpark as an estimate of the difference between the risk-free rates available in the U.S. and Japan.


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