Transcript of On-Demand Webcast: Will the Dollar Rally End in 2009?

02/05/2009 1:44 pm EST


Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

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Kathy Lien, Director of Currency Research, GFT
Speaker Bio:
Kathy Lien is the director of currency research at GFT, a world-leading provider of online currency trading services. Ms. Lien is responsible for providing research and analysis, including technical and fundamental research reports, market commentaries, and trading strategies to the media and the company's customers worldwide. Prior to joining GFT, she was a chief strategist at Daily FX and an associate at JPMorgan Chase, where she worked in cross-markets and foreign exchange trading. Ms. Lien has vast experience within the interbank market using both technical and fundamental analysis to trade FX spot and options. She also has experience trading interest rate derivatives, bonds, equities, and futures. Ms. Lien has written for Active Trader, Futures, and SFO magazines and is frequently quoted on CNBC, Bloomberg, Fox Business, and Reuters. She is also the author of the first edition of Day Trading the Currency Market as well as Millionaire Traders.

Boris Schlossberg, Director of Currency Research, GFT
Speaker Bio:
Boris Schlossberg serves as director of currency research at GFT, a world-leading provider of online currency trading services. Mr. Schlossberg is responsible for providing fundamental and technical analysis to the company's global network of individual and institutional customers as well as financial media outlets. Prior to joining GFT, he was a senior currency strategist for Daily FX. Mr. Schlossberg's career on Wall Street began more than 20 years ago with Drexel Burhnam Lambert, and during that time, he traded a variety of financial instruments, from equities and options, to stock index futures and foreign exchange. He is a weekly contributor to CNBC's Squawk Box and a regular commentator for Bloomberg radio and television. Mr. Schlossberg's daily currency research is widely quoted by Reuters, Dow Jones, and Agence France Presse newswires and appears in numerous newspapers worldwide. He has written for SFO, Active Trader, and Technical Analysis of Stocks and Commodities magazines. Mr. Schlossberg is the author of Technical Analysis of the Currency Market and Millionaire Traders.


Kathy Lien, Director of Currency Research, GFT
This is my colleague, Boris Schlossberg, and we're the Directors of Currency Research for GFT as well as for our new website, So if you haven't checked it out, it's the home of our commentary and analysis as well as the home for our technical analysts who give out trade calls on currencies.

Boris Schlossberg, Director of Currency Research, GFT
And for those of you who want to get a little bit more of a preview of the website, when we do our Trading the News seminar tomorrow we'll give you a full run through of what the website has, so come to that as well.

Kathy Lien, Director of Currency Research, GFT
So what we're going to talk about today is the outlook for the U.S. dollar. We're going to talk about whether we think the rally in the U.S. dollar is going to come to an end, as well as go through, you know, some of the major themes in the currency market right now. But before we do so, we're going to have to show you this disclaimer, just for a second or two, so that you know that trading currencies can be dangerous and you can lose money-trading currencies. And make sure that every trade that you put on is based upon sound analysis.

So this is our agenda for today.


Boris Schlossberg, Director of Currency Research, GFT
And we're just going to give you sort of a brief overview of the things that we're going to talk about. Clearly, 2008 was the year of volatility. We saw unprecedented moves in the FX market. We saw unprecedented moves across all asset markets and FX was not left out of the mix. And one of the reasons, of course, is because we've had just incredible dislocation in global economies and we're going to be talking about all of the after effects and the impacts of that dislocation as we go forward.

The central idea that has come out, out of all this dislocation, is that the world is almost uniformly headed towards zero interest rate policy; or in FX as we refer to it as ZIRP. That is a very, very important and key consideration when we are evaluating currencies as we go forward.

We're going to take a look at the outlook for the U.S. economy. We'll see what Obama's new China strategy means to the dollar and generally to the global economic trade and whether it could potentially be something very, very hurtful as we go forward. And we'll examine very, very importantly the other side of the equation of the most important currency pair that everybody trades, which is the euro/dollar. We will examine all of the key issues that are going on in the euro zone, and I hope to bring you up to date.

Sometimes when we're in America, we tend to ignore the news on the other side of the Atlantic, but the news on the other side of the Atlantic actually is impacting the euro/dollar in many ways more then the news on this side of the Atlantic, so we're going to discuss some of those issues as we go forward.

Kathy Lien, Director of Currency Research, GFT
There are also a lot of people who have been trading the British pound and you know that there's been quite a bit of action in the currency pair, so we're going to talk about whether the nets in the UK will finally be cleaned up or whether we have more trouble ahead. We'll also talk about Japan, about carry trades, about whether, you know, those are going to turn around any time soon.

And then we'll talk about, you know, where are the opportunities going forward. Which countries, which currencies will be the first to bounce back, and through that analysis we'll take a look at what could drive the euro/dollar, the pound/dollar, and dollar/yen, you know, in their next phase of trends in 2009.

So with that let's go ahead and talk about the big news in the currency markets. For those of you that may be trading currencies right now, you know that the big story in the currency market is that the U.S. dollar has been skyrocketing since 2008. Its been pretty much on a one-way up trend. Now some of you may wonder, why in the world is this happening? Because the U.S. economy is obviously in bad shape, the U.S. is in recession, also there has been tremendous layoffs and there's also been, you know, huge contraction in consumer spending. And U.S. interest rates are pretty much at zero. How can there be such strong demand for U.S. dollars.

Well the reason is twofold, and the reason is because number one, what we have is what we call save haven flows, meaning that in times of uncertainty, investors are willing to park their money with the U.S. government for no return. Just to put the money into the safety of the U.S. government, especially at a time when you have countries around the world that are at risk of lower credit ratings or even at risk of default.

Secondly, the reason why the dollar is skyrocketing is because of repatriation flows. That means a lot of U.S. investors who may have money abroad are finally bringing their money home either to meet their daily, meet their regular needs in terms of their cost of living or so forth; or you know, U.S. corporations may be bringing money home in order to dress up their balance sheets.

Now this is not just a story of the U.S. dollar, we have also seen the Japanese yen skyrocketing since 2008 and it's because of the same reasons. You know, we have a lot of Japanese investors who have lost a tremendous amount of money and they need, you know, they're starting to lose jobs too. In the past Japan used to be one of those economies where you would have a job forever. But that's no longer the case, because even Japanese corporations are cutting jobs. So therefore those investors who are making money you know, on their investments abroad, more so then they are, you know, in their investments domestically need to bring the money home in order to meet their daily living costs.


And same thing with companies, they need to bring the money home in order to pay their bills because they are losing money, and this repatriation flow is what's driving the dollar and the yen higher. Take a look at the big news that we've had in 2008 and into 2009. You can see basically since the summer of 2008 the euro/dollar has fallen significantly. In just the beginning, or towards the end of 2008, we had a 1,230 pip move over here in the euro/dollar which is basically an 8.75% decline.

We also saw an even more tremendous move in the British pound. Pretty much since the summer of 2008, the currency pair has fallen 30%. This shows you that trends are very, very strong in the currency market. This is a one-way up trend when we had the rally from the spring to the summer. One-way down trend when we had the sell-offs in the summer to the winter. And that's something that's very important to keep in mind because this is a trending market. You'll make a lot more money, you know, joining the trend here then trying to fight it and joining the trend on the down side rather then trying to fight it.

But the moves weren't just unique to the dollar because we also saw them in the yen crosses. You know you saw here, that euro/yen started off good up to summer, basically all the yen crosses and then fell 30% over a very short period of time. We also see a similar move in [Tao] yen which actually collapsed 12,000 pips. Even if you caught, you know, 120 of those 12,000 pips that would have been pretty significant. So the point is, you know, trends are very, very strong in this market.

Dollar/yen, dollar/yen hasn't seen as significant a move as the other currency pairs because we talked about how the dollar is strong, the yen is strong, because you know both currencies are benefiting from repatriations, safe haven flows. It's still fallen but not as much as the other currencies. This just shows you that against, between August of 2008 all the way up to February of 2009, dollar strength has pretty much been universal against every currency pair except for the Japanese yen. The Australian dollar has actually fallen the most against the U.S. dollar and basically five of these G10 currencies has fallen more then 20% against the U.S. dollar.

The yen, however, has really been the winner in 2008. Every single G10 currency fell against the Japanese yen at least 15%. And this is because also we had a large increase in volatility. The FX markets are getting more active. Back in 2006 the volatility in FX market was very small so were captured within a very narrow trading range. But volatility has exploded and this explosion of volatility is creating a lot of opportunity.

Now that currencies have fallen so much, you know, things have changed a lot. You know, some people may wonder for example, the British pound has fallen a lot, is it now undervalued? The Australian dollar has fallen a lot. The New Zealand dollar has fallen a lot. Well this chart shows you the valuation of a currency based upon purchasing power parity, which is a very, very you know, academic term and its got, you know, a lot of things that people think is good about it and bad about it. But I think that the point of this slide is just to give you context and that the New Zealand dollar -

Boris Schlossberg, Director of Currency Research, GFT
Wait, let me just ask anybody, does anybody know what purchasing power parity is? A simple way of looking at it is what's call the Big Mac index. Its what was the price of a Big Mac, which is a uniform product in any one of these countries, and that's how you would determine whether the currency is overvalued or undervalued. Because if in UK the Big Mac cost $5 and in New Zealand it cost $2, then clearly the pound would be much more overvalued then the kiwi.

Kathy Lien, Director of Currency Research, GFT
Okay, so based upon all these extreme moves in the currency market, the New Zealand dollar has actually become undervalued by 12.9%. The Australian dollar has become undervalued by 7%. The euro is still overvalued. The yen is obviously overvalued. So this creates context about how much more a currency could rise or fall because if they move very far away from their valuations we sometimes see those, you know, adjust themselves.

So what happened?

Boris Schlossberg, Director of Currency Research, GFT
The single most important thing that happened is that almost all the G10 interest rates started to really fall off a cliff. Central bankers across the world began to see the writing on the wall and began to really lower their interest rates significantly very quickly after the economic shock of Lehman Brothers happened. And as you can see this is the graph of the Fed rates, Bank of England, ECB, Bank of Japan and Bank of Canada.

Now a year ago, the only country that had a zero interest rate or near zero interest rate policy was Japan and that's why the carry trade was thriving. Everybody was selling the yen, buying everything else against it because there was significant amount of spread that they could bank every single day. All the other currencies had a substantial yield premium to the yen.

Nowadays, there is very little yield premium left. The only currency left standing with a 2% rate is the euro because the Europeans are stubbornly battling reality in my opinion, at this point, and even that is going to tumble come the March meeting when it's going to drop probably to 150. But look at the Bank of England, we're now at one, probably going to 50 basis points. U.S. is at 25 basis points, Bank of Canada is at one and probably is going to go to 50 basis points and what all of this means is that yield, which used to be the dominant variable that controlled currency trading, if you think about the currency era of 2000 to 2007 it was all about the carry trade, right? Everybody who was long carry made a fortune. What's really looking, what's really the story now is its going to be the anti-carry trade decade as we go forward because yield is going to matter not at all and the only thing that's going to matter is survival. It's really going to be the survival of the fittest, which is why despite all of the low yields that the dollar and the yen have, they are attracting so much capital.

Because now the question isn't a return on capital, but simply a return of capital. And all of us unfortunately know that part a little all too well in the last few months given everything that's been going on. I really hope there are no Madeoff investors here in this room. But the principal reason why, of course, central banks have been able to, to bring down interest rates so rapidly is because price levels have been collapsing, inflation which spiralled out of control just a year ago, has basically come down all the way to near zero percent.


And the critical reason for that of course is this factor. What was the single biggest difference from a year ago to now, in terms of prices for anybody who lives in a real economy? It's this, right? Oil. Basically $150 oil we were looking at what, $4.50, $5 a gallon in California? Now, we're back to $2. It's a huge, huge deflationary variable and that is the reason why all the central banks across the world have been able to lower their interest rates so rapidly without any fear of inflationary pressures.

Of course, oil is not the only factor that has had a major deflationary impact, the other deflationary impact that has had a huge impact is housing. Right? I don't need to tell you but if you are long housing, it's a very, very painful process right now. Now the way the U.S. government actually measures this consumer price index is skewed to the upside. Basically, they use something called owners equivalent rent which is not the true price of housing but the true price of rent, which tends to be actually much higher then the true price of housing.

This shows you what CPI would really be like if you would use what's called the Case-Schiller housing index which is the respected primary index of housing prices. That has collapsed tremendously and if you were to plug that into the CPI formula, you'd see that there's virtually no inflation at all. All of this allows the central banks to pretty much lower rates to zero without any fear of inflation going forward.

So that is the theme for 2009: yield no longer matters and the key trade is who's going to rebound next. So we're looking for the next Dennis Rodman.

Kathy Lien, Director of Currency Research, GFT
So right now, the story in the U.S., or the question in the U.S. is, are we in a recession or are we headed for a depression? There's an age-old joke that's been going around in the markets is that a recession is when your neighbour loses his job and a depression is when you lose your job.

Well there are many reasons why we could be closer to a depression then most of us would think. But first let's take a look at the only case of a recession in the past century in the United States which was the Great Depression of 1929 and take a look at how we compare to then.

Well, in 1929 unemployment was at 25%. Now the unemployment rate is about 7.5% and last week the Federal Reserve forecasted that at worst unemployment will hit 9%. GDP at that time was $7.5 trillion; our GDP right now is $13 trillion. Inflation or prices dropped 10% during the Great Depression; right now, we're still positive 0.1%. House prices fell 25% in 1929; right now house prices are only down 10%.

Boris Schlossberg, Director of Currency Research, GFT
Just wait.

Kathy Lien, Director of Currency Research, GFT
Whenever we have a very severe downturn in growth, its essentially a contraction in trade that happens between different countries. And actually world trade declined 65% during the Great Depression. As for equities, equities between September and October dropped 40% and over the next few years fell as much as 90%. To have the Dow Jones industrial average fall 90% from its peak would mean that the Dow Jones industrial average would be at about 3500.

That just gives you context of how close or far away we are from the only depression we've ever experienced. But there's actually different definitions of a recession and a depression. In a recession basically GDP growth is slowing, businesses stop expanding, unemployment rises and houses decline. But this recession is usually managed recession, meaning that the central bank is able to respond and able to turn things around by cutting interest rates.

Now the difference between a depression and a recession is that in a depression the central bank has run out of room to cut interest rates, which is sort of like what is happening right now. In a depression, the difference is that the central bank has no control over what's happening in growth and we've created an environment where the downturn is not manageable, which is kind of like what's happening right now; where the government can't get their hands around how to turn around the U.S. economy or the traditional monetary and fiscal policy initiatives aren't working at all. So if we go by the definitions of a depression or recession we may be closer to depression then we may actually think.

How long do recessions usually last? I mean its feeling quite bad right now. We are, I think the 14th month into a recession because according to the National Bureau of Economic Research we actually entered a recession in December 2007. So we're now 14 months into the recession. Well this is a little bit of an older chart. Well just to give you context, in the 70's and 80's, that recession lasted 16 months. During the depression, that lasted for 43 months. So it gives you a sense of, if you believe that this is the worst financial and economic crisis since the Great Depression, then growth will probably not pick up until 2010 at the earliest. And whenever we have an environment where we do have strong recession or strong downturn in growth, there always tends to be protectionism.


Now Obama just signed the economic stimulus package and there is a little bit of a buy America clause in there and the buy America clause basically says that if the U.S. is making sufficient quantities of whatever, we should by from U.S. firms. As every country tries to engineer some sort of protectionism, because they want the domestic firms to grow, and that is why, you know, ECB has no problems with the euro falling. The Bank of England actually is, you know, crediting the weakness of the British pound for stimulating their economy.

It's also the reason why Australia says that they're going to avoid a recession because they are able to engineer, because the currencies have fallen so much, they've been able to keep demand domestic. I think that that's where the U.S. will try to lean as well which is try to get demand as domestic as possible.

Can we spend our way out of a recession? It's sort of like what Obama is trying to do now. This is an older chart, we all know that the stimulus package now is $787 billion, not $900 billion. Well we're trying to spend our way out of recession which is kind of what Roosevelt did during the Great Depression. So the question is, will this work? I don't know whether it's going to work or not. I hope it's going to work.

But I do know that basically we have to figure that U.S. Americans will have to pay for it. And there's two ways of paying for it. A, we raise taxes which is basically robbing Peter to pay Paul; or we print money which is robbing Paul and giving him back money at a lower value. So either way what this tells us is it is probably dollar negative because printing money, raising taxes is not necessarily all that stimulative for the U.S. dollar. Instead, what we really need is some form of innovation to pull us out of the current recession.

Just to give you a perspective of how much we're spending, this is not even including the stimulus package on this current recession, that whole gray area is how we've spent so far. The other areas are the amount of money we've spent on a variety of other things like NASA, Gulf War, the New Deal, Korean War, the race to the moon, Louisiana purchase, it just shows you that we're spending a tremendous, tremendous amount of money.

Boris Schlossberg, Director of Currency Research, GFT
By the way, that's all in real dollars, so those are actual accurate comparisons of how much we have burnt relative to what little we have achieved with our money at this point. One of the interesting things that is really happening right now is that we are no longer a creditor nation so one of the very delicate dynamics that's happening in the currency market is that while we have the greatest amount of need for financing, we're also in the most vulnerable position to try to obtain that financing.

Because we do not generate excess capital; we are borrowers on the global scene. The people who are creditors, the people who do generate excess capital are the Japanese and the Chinese and as a matter of fact, one of the interesting things about the Japanese is they're becoming no longer generators of capital. One of the absolutely shocking things is that Japan is now actually running current account deficits.

But China still is the primary capital generator in the world, which makes China effectively our banker and our creditor. And with that-

Kathy Lien, Director of Currency Research, GFT
And this is the reason why Geithner, the new Treasury Secretary, receives so much heat. Everyone said he was a complete novice when he tried to brand China as a currency manipulator because China unfortunately holds the purse strings and they can come out and sell all the treasuries that they own which would drive up yields, which would drive up our costs, our mortgage costs, our credit card costs, everything that's related to interest rates.

So it's not necessarily the smartest move for them to do so.

Boris Schlossberg, Director of Currency Research, GFT
Yes, it was a huge political and economic faux pas. But there's even a more insidious problem with the Chinese position as it stands right now. The Chinese have been very smart. They roll, they used to have most of their money in what's known as agencies; basically Fannie Mae, Freddie Mac, mortgage-backed securities. They have rolled almost all of their investments from those securities into treasury bills, treasury notes. They went from a longer-term duration to a much shorter-term duration.

And what this means is that they get to roll over their debt at much shorter duration periods. They can roll it over effectively every six months to a year. They don't have to sell. All they have to do is simply stop buying in order to trigger one of the most calamitous problems in the United States financing history. Because if the Chinese simply stop buying, treasury auctions fail and whenever we play all these what-if scenarios, the greatest catastrophe scenario for the dollar that we always envision is the failed treasury auction.

Because if there is no demand for dollars, I mean, really what is a dollar? It's a piece of paper, right? It's really a paper tiger, right? The moment somebody says, I don't want this tulip, the bubble really begins to burst. And that is the one key thing I think that everybody's very, very conscious of and is watching very carefully. That's why one of the most important things to watch, aside from economic data this year, is going to be treasury auctions.

For now, the Chinese very well understand that they cannot simply walk away because they will be cutting their nose to spite their face. We still are one of the dominant markets into which they can sell products into. And if they simply cut off our financing, they cut off all of their own export growth. But, push may come to shove, and even if they simply curb their appetite substantially, it could come to a stress point where the treasury auction fails. So that is one key news event you should really watch for carefully. Should that occur this year, it could be very dollar negative.


This is a growth of, you know, Chinese economic growth and one of the I think shocking things is everybody had this great theory, decoupling, China was strong enough, was big enough, had its own domestic demand even if the west stopped buying its own goods, the Chinese were going to be able to sort of survive and grow at almost double-digit rates irrespective of demand in the west. I think clearly the last few months, if nothing else, have shown us the fallacy of single country strength thesis.

Basically in an internet connected, globalized world we all swim together and we all sink together. I think it's pretty clear. I mean every elegant economist I've seen on TV used to always put out these things, well its only 10% of Chinese GDP, its only a very, very small portion, exports really don't matter. Of course, they matter, because they are the margin of the periphery that drives the rest of the whole country forward and what you're seeing now is this utter and complete collapse of Chinese growth within their own economy.

Which means that they may have to be able to take their own money and stimulate their own economy instead of using it to buy our treasury bonds. Yet another very serious stress point.

Kathy Lien, Director of Currency Research, GFT
That's actually a really good point because China right now has to use their reserves domestically and try to stimulate their own growth and may not want to buy that many treasuries going forward. So that could also hurt the dollar.

Boris Schlossberg, Director of Currency Research, GFT

Kathy Lien, Director of Currency Research, GFT
This is just a chart to show you that in past recession the dollar tends to fall in the first six months and then rise in the next six months. So we're kind of seeing that pattern unfold as well whereas the dollar first fell, remember, from December 2007 all the way up to the summer of 2008 and then now is embarking on its uptrend, which is typical of what it does during recessions.

Boris Schlossberg, Director of Currency Research, GFT
Right, because the underlying assumption in all of this price action is that we are going to eventually rebound and of course remember I said to you first the rebound is first to gain in the currency market, that's the strategy that's playing out.

Kathy Lien, Director of Currency Research, GFT
The point that we want to show in this chart is that this recession is the worst since the 1980's, right? So in the 1980's, where the circle shows -- this is the dollar index -- we first have a rebound in the U.S. dollar.

Actually let me get a little more specific here, first we have this sell off here which is what happened in the summer of, in the beginning of 2008. Then we had this rally that we're undergoing right now. Then we have a sharp collapse of 10% and that could be where we're headed which is this huge correction later on, if you believe all the things that we just talked about. And this is just, you know, based upon how the dollar index performed during the 1980's recession.

Boris Schlossberg, Director of Currency Research, GFT
Now the critical thing is that yes, of course the situation in the United States is pretty dire, but you look at the other side of the Atlantic and it's hardly better. Because one of the problems with the euro zone is, that euro has really been, over the last 10 years, it's become a very viable alternative to the dollar. But it suffers from one glaring structural flaw. It is the only currency in the world without a country. Because of that, it doesn't have political control. It doesn't have the kind of national unity control over its member nations that all the other countries that have their own currencies have.

I was talking to Bloomberg this weekend and I actually used a joke that Kathy told me, what's the difference between Ireland and Iceland? And the answer was one letter and the fact that they are in the euro zone. The problem with the euro zone is that they're having some very, very serious stress issues on their side of the equation --she's laughing, because I actually quoted that, that joke.

Kathy Lien, Director of Currency Research, GFT
The joke is, what is the difference between Ireland and Iceland which is one letter and six months; but in reality it's because they're in the euro zone.

Boris Schlossberg, Director of Currency Research, GFT
They're in the euro zone, right. All of this is compounded by one very interesting fact. The ECB still believes it's the Bundesbank and it still thinks its 1920's Weimar Republic. They still fight, you talk about generals fighting yesterday's battle, they still are under this foolish impression that they have to fight inflation and have kept rates unnaturally high relative to the kind of collapse in growth that they have had in the euro zone.


Jean-Claude Trichet is known as the godfather in the currency business because he's incredibly tough on monetary policy. But that is starting to really backfire on them because for the first time in three years German unemployment has actually become positive; that means they are now starting to lose jobs. And woe is to any politician or monetary policy maker that's going to be responsible for an increase in German unemployment because that is going to create such tremendous political tension in the euro zone, that the ultimate question of why the euro has been declining is whether a currency without a country could survive this mess.

The ultimate bet of all the euro sceptics is that it may have to break up. And therefore it's sort of like in the land of the blind, the one-eyed man is king. Despite all the horrible problems we have in the U.S., it makes the dollar look a lot better then the euro. One of the primary reasons why you've had this huge run up in the dollar aside from the rebound issues and all the other stakes, is simply a complete lack of faith of confidence in the euro zone as a viable entity.

Now the other interesting story is the UK economy. The UK economy we always called the world's first hedge fund economy because 50% of all jobs in United Kingdom from 2001 forward were generated in the financial sector. London of course sits right between Middle East and North America and has been the primary intermediary between all the petro dollars coming out of Russia and the Middle East and placing them into securities in North America at the global capital markets.

So London in many ways actually became the global finance capital in that enormous go-go days, 46 consecutive quarters of growth created tremendous boom in the UK economy, all of it now just completely blown up. I was just in UK a month ago, it looked like a neutron bomb hit the city. It was incredible at how empty and slow it was in many ways.

Kathy Lien, Director of Currency Research, GFT
And this is part of the reason why the British pound is so much more volatile then the other currencies. You can see that moves extend much longer, and the intraday basis is also a lot more fluctuations, because there are so many speculators in the UK economy in the British pound.

Boris Schlossberg, Director of Currency Research, GFT
I think nothing shows the blow up better then the rise in unemployment claims. I mean, in 2004, 2005, 2006, UK unemployment was 2.2%. It was just astounding. It's now above 6%. It's been a huge shock to the system. But one of the interesting things about UK and one of the things that we're starting to see right now is that we're actually starting to see some stabilization in a lot of early signals, what we call PMI, data PMI services, PMI industrial, PMI construction, all those surveys have actually shown that the economy has stabilized.

And just like driving a car, you cannot go from neutral to first, you cannot go from reverse to first before going into neutral first, same thing with economies. Before things get better they have to stop getting worse. An interesting thing about the UK economy because they've been very, very aggressive on their monetary policy and fiscal policy is things may have -- may have -- stopped getting worse.

And one of the more interesting trades that we're watching is the euro/pound because we think that may have topped. In other words, euro/pound ran to the stratospheric near 1:1 parity on the assumption the UK economy was basically going to collapse. Now it looks like its going to be the euro zone economy that's going to collapse and the UK economy that may stabilize and that presents a very interesting short in the euro/pound for long-term investors.

Of course the other big story that we saw is the sheer destruction of Japanese economy. Who in, I think their right mind would have thought that complete collapse of the global financial system would impact Japan, a country with the least amount of exposure to that system. The worst.

And of course the reason why is twofold, two things happened. Japan is a mercantilist nation. It basically makes all its money through an export-driven economy. The first thing that happened once global demand came down is that they stopped being able to sell any of their products.

The second thing that happened is this massive appreciation of the yen so Japanese corporates basically got squeezed from both sides. Suddenly their prices went up because they pay their workers in yen but now they have to generate income in euros and dollars which are much weaker against it and they have to generate much less of those dollars. And they're not getting any demand on the outside world, so it's a double whammy that created this incredible toxic shock for the Japanese economy, to the point where we're now actually running current account deficits in Japan; unthinkable. Toyota firing people; unthinkable. Panasonic firing people; unthinkable. This is in a land where almost universal employment is practically guaranteed. They just don't know what to do at this point because they cannot control the yen, they cannot stimulate demand, they are trapped under the circumstances not of their own making. Talk about a drive-by.


Look at this picture. This is Japanese industrial production. This is depression-like statistics. This is a fall off a cliff if you can possibly imagine it, of what's really happened to Japanese industrial production. That is a result of very high yen and very low global demand. The question is, is the BOJ going to intervene and then the bigger question is is it going to work for more then two minutes and the five seconds that the intervention actually happens?

Obviously I think the -- imagine a line, the line in the sand for dollar/yen is 85. Now one of the things that's been happening over the last few weeks is we've actually seen a little bit of a pick up in dollar/yen as some risk appetite has come back, as some flow has come back into the dollar strength. U.S. interest rates have actually picked up.

One of the interesting things that we want to watch when you're trading dollar/yen is two-year treasury bills. It tends to have a lot of correlation, it means the higher the yield on U.S. two-year treasury bills, the higher dollar/yen tends to go. So as people begin to worry a little bit about U.S. credit and start to price U.S. credit a little bit higher, it actually is positive for dollar yen, positive for the Japanese economy.

Everything is screwy. What's bad for the world is sort of, in many ways, good for the Japanese economy because it helps the yen depreciate.

Kathy Lien, Director of Currency Research, GFT
We actually wrote an article on that talked about why dollar/yen is decoupling from equities, because for very long periods of time over the past year or two, dollar/yen has pretty much been moving in lock step with equities, meaning that if we have bad U.S. data that pushes equities lower, dollar/yen will fall. If we have good U.S. data that pushes equities higher, dollar/yen will rise. But actually we're seeing a decoupling of dollar/yen not only with U.S. equities, but also with Japanese equities.

The reasons for that, and we show a chart in our article on FX360, is because volatilities are coming down and the way to think about it is that carry trades usually perform well in three environments. One where we have the central banks actually raising interest rates and not cutting interest rates. We also have low volatility and we also have strong risk appetite. So one of the three is already beginning to improve, which is lower volatility and that's why dollar yen is rising even though the Dow Jones industrial average broke a very, very critical mark on Friday.

But because the trend between dollar/yen and equities is one that has lasted for many, many years, it should just be a matter of time before that divergence comes back once again and dollar/yen will once again move along side-

Boris Schlossberg, Director of Currency Research, GFT
You mean correlation.

Kathy Lien, Director of Currency Research, GFT
Correlation will move alongside equities. So one of the charts that we didn't talk about - what happened to the -

Boris Schlossberg, Director of Currency Research, GFT
We have five minutes here, that's why we have to go through -

Kathy Lien, Director of Currency Research, GFT
It's okay, I just want to show that chart for a second. The one chart that I wanted to show you is the chart of Japanese investors. For a long period of time Japanese investors were the biggest buyers of the yen crosses. But actually according to data from Japanese FX brokers they've actually turned short yen crosses, which is a huge deal because in the past they were afraid of being short any carry trade because you had to pay a lot in interest rates rollover on a daily basis.

But because interest rates have fallen so much, now it doesn't cost so much to go short, to carry trades. So actually Japanese investors, or Mrs. Wantanobi, which used to be the Japanese housewife, is joining the move lower in the yen crosses; the move lower in dollar/yen, pound/yen, euro/yen, and usually they tend to be right.

So the key question is who will bounce back first? The countries that will bounce back first are the ones who's currencies have fallen the most. Meaning Australia for example, New Zealand for example, maybe even the UK because currency rates really, really impact the demand of foreigners for the goods that are made in Australia, and the UK and New Zealand for example. All these central banks have credited the weakness of the currencies for really keeping the economy from slowing even further.

The countries that will continue to suffer longer then everyone else will be Japan, and maybe in some places, even the U.S. to some degree because the strength of the currency will have a lasting impact on those countries. So the way to think about it is that when the dust settles the countries that will recover the first are the ones whose currencies have fallen the most.

Boris Schlossberg, Director of Currency Research, GFT
Now we like to play a thud game always when we do an outlook on majors, what can make things go up, what will make things go down because this helps you frame the question when you're doing your analytics as you go forward in your day-to-day trading. And once you see a certain part of the theme develop it makes it much easier to say yes, this makes sense to be long or short - excuse me -- or it makes sense to be short.


So given that occurrence, what's going to make your dollar go up, what's going to make your dollar go down? Let's take a look at the upside. The most likely scenario is that euro zone economy actually could surprise, that somehow they could find a bottom, somehow they could find demand for their products which is a very export-driven economy, and actually stabilize.

The north-south problem in the euro zone which is that the northern economies which are much more productive then the southern economies does not lead to essentially a break up of the euro zone. If they can paper over their differences and survive for a little bit longer, and then not have the economy go completely into the tank that will give the euro a little bit of a boost. Remember the euro is trading in some ways on the assumption that it could potentially break up and that if those concerns go away that will really help the euro on the upside.

The other question is of course the anti-dollar question; the one that I talked about earlier, U.S. treasury auction does not meet demand. A failed treasury auction would simply create flow through euro as just an alternative as the next best thing, alternative to the dollar given the fact that people will begin to fear that U.S. cannot finance its way out of these problems.

And, global capital markets also begin to stabilize. The euro trades very much in concert with risk appetite. If equities rise, euro tends to rise with them because it means global demand is going up and the export-driven economy of the euro zone is going to benefit from that dynamic.

So if you see global equity markets starting to have a little bit of a rally, that's definitely going to help the euro. And those are the three reasons for why we could have the euro potentially go up this year, granted not very strong thesis, but a thesis nevertheless.

Kathy Lien, Director of Currency Research, GFT
The single biggest reason why the euro dollar could fall and the single biggest trigger is if the time bomb in eastern Europe explodes, basically a lot of banks in western Europe in countries like Austria, in countries like Germany for example, have lent heavily to countries in eastern Europe or to borrowers in eastern Europe. So its kind of like the scenario where we had in the U.S., kind of like the subprime crisis where a lot of banks lent to very bad credit borrowers. The same case is sort of happening in Europe because a lot of western banks lent to some eastern European borrowers which may not have had the best credit. If they start to default on their loans, that's going to certainly have an domino effect on first the banks, so they would report [inaudible] or write down.

And then secondly those banks may require bailouts from the government which could just trigger another financial crisis in the euro zone. So that's the single biggest reason why the euro/dollar could fall because the possibility of this happening is growing very real.

Also Ireland, Ireland is at risk of defaulting too. So if a member of the euro zone defaults just like we've seen when Spain and Greece had credit downgrades, there tends to be an exodus out of euros by investors.

So those are the key event risks to watch. It will help if the U.S. economy responds to stimulus and actually is the first to rebound from the global recession but that may not happen until 2010. The biggest more pertinent risk is the time bomb in eastern Europe.

Boris Schlossberg, Director of Currency Research, GFT
One of the interesting things about the eastern European debt is remember that most of these mortgages in eastern Europe are denominated in euros or Swiss francs and east Europeans who are holding crona or the Polish zloty who have had depreciation of 50% simply can't meet those obligations. That's the real tragedy, its not so much that they don't have money, its that they have huge depreciation in their own currency and they have to pay out the mortgages in the euro or the Swiss currency.

Now UK, what can make UK go up. Remember one of the interesting things that I think is a thesis is that UK may be the first economy to actually rebound because it does seem to be stabilizing. We've had PMI data be better. Just this Thursday we had much better then expected retail sales. There are all these bubbling signs on the surface. Perhaps its just a pause that refreshes before a new drop forward, but at least for now all the economic data is showing us the UK economy is beginning to stabilize because they've been very, very aggressive on their fiscal and monetary policy, they've poured tons of money into their banks.

They've had huge amount of fiscal stimulus into the economy. They've been very quick to respond and they've lowered their rates very, very quickly to 1% to probably to 0.5%. So all of those things along with potentially a global capital market rally, can help the pound rise higher. And of course the final reason is just simply the dollar reason, if we do have a collapse in the dollar, the pound would just get simply a little bit of a flow on that prospect alone. But generally I think the pound, especially on the euro/pound cross could be a very interesting trade as we go forward this year.


Kathy Lien, Director of Currency Research, GFT
But despite the improvement in UK economic data, the Bank of England wants to continue to cut interest rates. They actually expected to bring interest rates all the way down from 1% to U.S. levels of 0.25% and they're going to start to print money and buy UK gilt. So those two things could singlehandedly push the British pound lower even though we're seeing signs of stability because the Bank of England isn't giving up.

So what we believe is that first off, the pound could still suffer because of the outlook for lower interest rates, but when the dust settles because they've done so much with fiscal and monetary policy because the currency has weakened significantly, they'll be one of the first to really rebound.

Boris Schlossberg, Director of Currency Research, GFT
Forget the yen, yen always gets no respect. It's the Rodney Dangerfield of currencies. What can make the dollar yen go up? Obviously still pretty serious correlation with risk assessment and if Dow begins to rally, if Dow above 8,000 is certainly going to bring dollar yen potentially to a maybe 95, maybe even 100. That is still a very serious correlation. Also if rates on the two-year treasuries begin to percolate up, but funding continues, that is maybe we can just simply raise rates and that will be enough to attract the Chinese to keep giving us money, that will create a little bit of a power move in the dollar/yen and help us bring it up.

Japanese economy begins to recover slightly; the higher the dollar/yen goes the better it is for the Japanese economy. So its sort of a chicken and egg situation. If dollar/yen continues to go higher and goes to 100 its going to make it a much easier for Japanese economy to breath and hopefully help it.

And BOJ begins to intervene, an unlikely scenario but one that could very well be possible if they get to the point where there is just simply, they have to cry uncle at 85 to yen.

Kathy Lien, Director of Currency Research, GFT
On the plus side, dollar/yen will fall if the Dow keeps on falling. I mentioned about how its kind of moving in opposite directions right now, but that cannot last for long. So if the Dow hits 6000 or at least heads aggressively in that direction, expect dollar yen to reverse and head there as well.

Also, all the things that we talked about which is more repatriation by investors back into Japanese assets could also help to boost the yen against the U.S. dollar. But those are the key things to focus on which is U.S. equities and dollar/yen and that really could impact how the currencies are trading.

So we've run out of time, we're going to take questions as we go out and in our booth on the sixth floor. Just so you know on Monday I'm publishing an article on called the Race to Zero Interest Rates. So you can pick up the access pass to the URL or you can write it down, So like we said, we would be delighted to take any questions. I think we have run out of time here. Someone else is taking the booth. So please come up, and then we'll be making our way down to our booth on the sixth floor and we'll be answering questions there as well. Thank you so much for attending.

Boris Schlossberg, Director of Currency Research, GFT
Thanks guys.

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