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Weekly Insight

Not so smart now

CHICAGO (GlobeinvestorGOLD) - Last month, some of the sharpest investors on the planet got it wrong with the U.S. dollar.

Macro hedge funds invest in stock, bond, commodity, and currency markets by monitoring large economic trends. They showed their worst returns of the year in October, stemming mainly from being short the greenback. According to the CSFB/Tremont Index, returns for this hedge fund category dropped by an average of 0.86 per cent last month, with the bigger funds dropping more than 2 per cent. And then thereís the Oracle of Omaha, Warren Buffet, who pared back about 20 per cent of his $21-billion (U.S.) short position after losses of $900-million.

Whatís going on here? Or better yet, why is the buck confounding the best and the brightest? It seemed such an easy call in September with the hurricanes, higher energy prices, problems in Iraq, and President Bushís sinking approval ratings. How can the greenback strengthen when the U.S. ran a $66-billion a month trade deficit in September and has a yearly current account deficit getting close to $800-billion?

Because it can. Because it can handle all of the above and have an economy that keeps on clicking along like all of that is just noise.

But letís break it down and show how even the big boys can get it wrong. Keep in mind that even Federal Reserve Board chairman Alan Greenspan has said predicting currency movements is no better than flipping a coin. Hereís a quick-and-dirty primer on the factors that move currencies:

Interest Rates

Letís jump back to the summer of 2003. The federal funds rate hit a low of 1 per cent and the European Central Bank pushed its benchmark rate down to 2 per cent. This aggressive easing by the Fed helped bring the U.S. economy out of a mild recession, but also helped take the dollar down. Interestingly, the dollar did not set new lows at the time. It happened after the Fed started raising rates. Why? Because it took time for the market to shift away from bearish expectations and to understand the dynamics of why U.S. rates would continue to rise. Now, fed funds futures are anticipating rates to rise to 4.50 per cent by February and European rates to remain at 2.0 per cent.

Economic Growth

U.S. interest rates have climbed due to strong economic growth and rising inflation. The prior period of extremely low interest rates generated amazing growth in construction and real estate. Some estimates have shown that half the jobs created from 2001 have come from this area of the economy. The key is the shift and not the sector. This is the major difference between the U.S. and other major economies: Flexibility. Economists are raising their expectations for U.S. GDP next year to be between 3.0-3.5 per cent while Europe is stagnating.

Relative Productivity

The U.S. just announced a surprise jump in productivity to 4.1 per cent. Letís hear from Mr. Greenspan on this: "Greater rates of productivity growth in the United States, compared with still-subdued rates abroad, have apparently engendered comparable differences in risk-adjusted expected rates of return and hence in the demand for U.S.-based investment assets." In other words, companies can earn higher profits and pay their workers more money. This is why many medium term econometric models that attempt to predict currency direction have relative productivity as a key positive variable.

Reserves

The Chinese are the main culprits when it comes to accumulating massive amounts of dollars. Although they recently allowed the yuan to appreciate 2.1 per cent and have small daily movements, the Chinese continue to control its movement and support the dollar. Essentially, the Chinese intervene every day to buy dollars and supply yuan. This means the Chinese accumulate dollar reserves. They now have over $800-billion in dollar reserves. In the Far East, itís estimated that there are now over $2.5-trillion of dollar reserves held by central banks. This means that the U.S. can continue to run a massive trade deficit with China ($20-billion a month) without having any negative currency repercussions.

Sentiment

This is the mood of the market as it attempts to digest all of the above and then some. Sentiment is tricky, but itís just like inflation expectations. It doesnít matter what inflation actually is, itís the anticipation of inflation that counts. Back in December 2004, people didnít expect the Fed to keep raising rates and they sold the buck. Now, the market is fully anticipating rates at 4.5 per cent. If the Fed goes on hold at either of the next two meetings, you can bet the buck will drop as the market adjusts its expectations.

Ok, nobody said this was fun or easy. These five areas are gross simplifications of the complex dynamics that make currencies move. Foreign exchange markets can shift focus from bird flu to French riots to CIA leak scandals all in the same trading session. I find it comforting to know that even the most sophisticated can get it wrong once in a while.

This article first appeared on GlobeinvestorGOLD.com. If you'd like to profit from the insight of more than 30 financial experts and columnists, including Andrew Busch ó sign up for a free trial to GlobeinvestorGOLD.com.

© 2007 The Globe and Mail. All rights reserved.

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