Bilal Hafeez has a simple message for the buy-side: "We're bearish on the US dollar."
It's not a message that most clients want to hear. "They usually disagree," he says. "I think the euro will go much higher against the dollar, but the news is weighed down by issues around European banks' exposures to Eastern Europe and the fate of European monetary union."
Hafeez is global head of FX trading strategy at Deutsche Bank. Based in London, he has been on a tour to speak with money managers, hedge funds, asset owners and corporate treasurers in Europe, America and, this week, Asia.
Client interest in foreign currency has rocketed because FX volatility has become overpowering. Managers of other asset classes such as equities used to assume that returns in the underlying were most important, with currency movements an irritant or icing on the cake. Since the massive swings of the fourth quarter in 2008, however, currency is now dictating overall performance.
Secondly, FX markets remain the most liquid in the world, even more so than US Treasuries. Therefore investors are considering taking views on currency as an asset class - including, for the first time, players in unlisted assets. Private equity and private real estate investors used to ignore currency; returns in their businesses were so high that FX didn't matter. Today many PE firms are suffering from terrible performance, and their returns risk being overshadowed by currency.
Even asset owners such as pension funds, insurance companies and central banks are taking a more active interest in FX, says Hafeez. These views are mostly expressed in the spot and forward markets, as well as some simple options in the most liquid currencies.
Forwards don't require capital up front, so they are easy for private equity funds to trade. Of course, if the trade ends up out of the money, a PE fund would have to pay out of its own capital, but in most cases these bets are being made as hedges, so presumably the underlying asset is coming good.
These investors tend to adopt big-picture, top-down views. Hafeez says in today's environment there are two such camps: "Either the world is ending, or it's not." Other investors, particularly those with more flexibility, such as hedge funds, can adopt more disciplined, finely tuned strategies around valuations, currency trends and carry trades.
Today of course the trend is dollar strength, not out of love for the US economy, but a belief that it is under less strain than others. Hafeez argues, however, that investors should not focus on which economy's GDP growth rate is better or worse. "Currency is about who prints the most money," he observes, noting that many Asian markets have enjoyed strong economic growth while maintaining weak currencies for years.
He believes the dollar's strength will ebb once the Federal Reserve Bank starts to buy Treasury bonds to support the Obama administration's budget deficits -- and the effects will materialise faster than anyone now expects. Hafeez reckons today's rate of 1.25 dollars per euro will reach 1.5 by summer.
"These negative stories about Europe have been around for three months now and the markets will get tired of them," he predicts. "US bond yields are already moving a little higher, which suggests the Fed will act to loosen monetary policy and buy Treasuries."
Dollar weakness is also likely to be expressed in yen/dollar rates and gold, but less so. Asian governments will continue to favour weaker units against the dollar in order to protect their exporters. The Bank of Japan may also intervene but can only do so much given the size of the Japanese economy.
Fortunately dollar weakness should not harm Asian investors, as their local units will also weaken in tandem. The Fed will continue to buy Treasuries, which will support yields. And the global flight to Treasuries in Q42008 suggests that a dollar crash is very unlikely, since the dollar gets inflows at the first sign of trouble.
Rather, the implication for Asian investors is the balance between their euro and dollar-denominated exposures, not their own currency's position against the greenback. Another implication, for everyone, is that the Fed's buying spree is going to create inflation -- but Hafeez reckons this is a problem for 2010 and beyond.
Hafeez is sceptical about gold as a hedge against a weaker dollar. This asset class has three fundamental sources of demand: industry, central banks, and retail investors in China and India. None of these are active buyers; the recent hike in gold prices is mainly from speculators -- gold bugs -- who fear the worst. Even if the gold bugs are right, sophisticated investors will find other ways to express their concerns. They can simply sell dollars in the forwards market, or they can buy inflation-linked bonds, which today price inflation very cheaply.
So what about all the bad news in Europe? Hafeez says investor attention is going to wane. First of all, the problems among west European banks' exposures to the east can become dwarfed by new troubles in the US (credit cards, anyone?). Secondly, the Italys and Greeces in the European Union would find quitting the euro too painful to contemplate (their existing debt would still be euro-denominated). Thirdly, a default by the likes of Ireland is feasible but the European Central Bank has proven its ability to hold member sovereign bonds as collateral and ensure all bondholders are protected.
