At this time last year there was a lot of talk in the financial press
about the huge US$ short position that was associated with the
dollar-denominated debts racked up over many years in emerging-market
countries. This debt-related short position supposedly guaranteed additional
large gains for the Dollar Index over the ensuing 12 months. But now, with
the Dollar Index having drifted sideways for 12 months and having had a
downward bias for the past 5 months it is difficult to find any mention of
the problematic US$ short position. Did the problem magically disappear? Did
the problem never exist in the first place?
Fans of the US$ short position argument needn’t fret, because the argument
will certainly make a comeback if the Dollar Index eventually breaks above
the top of its drawn-out horizontal trading range. It will make a comeback
regardless of whether or not it is valid, because it will have a ring of
plausibility as long as the Dollar Index is rising.
I’m not saying that the argument for a stronger US$ driven by the
foreign-debt-related US$ short position is invalid. I’m not saying it yet,
anyway. The point I’m trying to make above is that if the argument was
correct a year ago then it is just as correct today (since debt levels
haven’t fallen) and should therefore be just as popular today. It is nowhere
near as popular, though, because most fundamentals-based analysis is
concocted to match the price action.
I actually view the “global US$ short position” as more of an effect than
a cause of exchange-rate trends. Major currency-market trends are caused by
differences in stock-market performance, real interest rates and monetary
inflation rates. When these factors conspire to create a downward trend in
the US dollar’s foreign exchange value it becomes increasingly attractive for
people outside the US to borrow dollars. And when these factors subsequently
conspire to create an upward trend in the US dollar’s foreign exchange value,
debt repayment becomes more costly for anyone with US$-denominated debt outside
the US.
So, if the Dollar Index resumes its upward trend later this year then
anyone outside the US with hefty US$-denominated debt will have a problem,
but the deteriorating collective financial position of these foreign US$
borrowers won’t be the cause of the dollar’s strength. It will just be a
popular justification for the strength.
In general, fundamentals-based analysis will look correct and achieve
popularity if it matches the price action, even if it is complete nonsense. A
related point is that if fundamentals-based analysis is contrary to the
recent price action then hardly anyone will believe it, irrespective of the
supporting facts and logic.
