It was all about the dollar and the euro

Thanos Papasavvas, head of Investec’s currency management team, talks to Tomas Hirst.

Q: How strong was the dollar’s position at the onset of the subprime mortgage crisis?


Basically when investors first started investing in the euro they thought they were investing in the Deutschmark. It was only afterwards they realised what they were investing in was not the Deutschmark but something closer to the French franc or the Belgian franc, because it includes the lower credibility currencies like the Greek, the Spanish and the Italian.

Once they realised the currency they were buying was not the one they thought they were buying, which coincided with all the foreign investments into the US in the late 1990s, it led to the euro collapse. This saw 16% weakness in the euro in 1999 and another 16% weakness in 2000, and that’s when the Europeans, the British and the Americans came in to prevent the euro creating a serious political problem and destabilising the whole geopolitical situation. This led to the dollar getting a bit overvalued.

What we saw since then was one year of stability from 2000 to 2001 and after that we saw the September 11 effect, the stockmarket crash in the US and the fear of a possible depression moving into the likes of Japan. This led to ‘benign neglect’ by the US authorities to allow the dollar to weaken and help the US economy to recover.

Although the US Treasury was always saying they believed in a strong dollar policy, they still allowed the exchange rate to weaken. We believe that what policymakers meant is that for the US consumer, a dollar in the pocket would have the same purchasing power tomorrow as today. In other words it’s about keeping inflation under control and the purchasing power parity of the dollar strong.

They were happy with a weakening dollar as it helped exports and could be used as a monetary policy easing tool. These were all positive signs.

Q: Has the dollar’s relative position against other global currencies been weakened by the events of the past 12 months?


What happened last year is that [from] the beginning of 2007 to the middle of 2007 we saw the first signs of volatility picking up. Until then volatility in the FX (foreign exchange) markets was declining at a very steady rate.

As volatility tends to go down consistently for a number of years, markets become a bit complacent, positions are increased because volatility isn’t there to make people alter positions or close positions, and leverage is built up.

Also in those low-volatility periods, quantitative models tend to work well. This is because in low volatility-trending markets, quant models, which tend to be backwards looking, can forecast what is going to happen based on what was happening before.

With the realisation last year that a serious economic event was taking place, volatility began jumping aggressively, as we saw in the summer, and we saw a total change from the low volatility, pro-carry environment. Uncertainty crept into markets and people realised there was a lot of de-leveraging that needed to take place in positions. This caused currencies like the yen and the Swiss franc to strengthen as high-yielding currencies weakened.

This brought us to the end of last year, and up until that point it was not certain as to how the US economy was going to do in this environment.

From the beginning of this year we felt that the economy was going to be adversely affected and that the Fed was going to have to be very aggressive in cutting interest rates. As a result, the dollar was going to have to weaken against other major currencies. The first four months of 2008, therefore, was all about dollar weakness.

Once the Fed was done cutting rates at the end of April, our view started to change. We felt that when the Fed reached its trough [in terms of interest rates] then the dollar would start to recover, and as the US economy started to recover, the dollar would strengthen against other currencies – with other central banks having to continue cutting rates.

The big shock was when Trichet [Jean-Claude, the president of the European Central Bank (ECB)] surprised the market in June with his hawkish statement that the ECB would be increasing interest rates because of the commodities rally. That took the euro to above $1.60 and the dollar to a low for the year.

From July onwards, however, markets realised that the US economy may have had a rough time but it was stabilising and recovering, whereas the eurozone had only just started deteriorating. We saw a very sharp move as the dollar strengthened much faster than we would have expected, as participants in the market were completely surprised by it.

We have now reached a level, with the euro around $1.40, where the situation should stabilise. The question is, however, is this the end of the economic cycle?The discussions that we’ve had over the past week have focused on the story of the yen because right now [in the wake of Lehman Brothers declaring bankruptcy] it is attracting inflows as a safe haven. We are no longer positive on the dollar as we’ve reached the level we thought was fair value.

Q: Do you think that sterling is now coming close to fair value against the dollar?


If we are looking at sterling against the dollar, we tend to let our euro/dollar view drive that. We believe the euro/dollar drives sterling/dollar not the other way round.

The sterling/dollar exchange rate can be influenced by numerous factors, whereas the sterling/euro rate is more relevant to sterling and euro dynamics, so it’s a purer way of assessing sterling valuations. We think sterling has certainly cheapened up quite a bit and there’s maybe a little bit more for it to go. That said, we are close to approaching levels where sterling will be attractive against the euro.

The eurozone is the laggard of the credit crunch. The US economy was the first, the UK economy was second and the eurozone was third.

Q: How important is the appreciation of the renminbi against other currencies for the global economy?


One of the successes of the US Treasury secretary Paulson has been to improve the diplomatic relations between China and the US. I think that was why he got the job in the first place, based on his experience of working with China at Goldman Sachs. So when he came over to the government he was able to help the Chinese to not lose face but yet allow the currency to appreciate at a gradual pace.

The renminbi has been appreciating against the dollar, albeit at a slower pace than the US would like, but at least it is a small step in the right direction. The problem that the Chinese have is that if their currency is stronger than the other regional currencies then it puts them at a disadvantage in terms of their exports.

THANOS PAPASAVVAS is the head of Investec Asset Management’s currency management team.