Friday, November 03, 2006

Right view, wrong vehicle for the $ bears

As my friend Stephen Plant and I learned while working for a NY hedge fund, there are two aspects to a good trade, divining the macro trend correctly AND implementing that view using the right vehicle. There are few things more vexing, as Warren Buffett and Robert Rubin have recently discovered, than divining the macro trend correctly, but implementing the trade using the wrong vehicle.

For instance, if you want to go long petroleum, buy the strongest component. Going into winter, other things equal, heating oil tends to be a better bet than crude or unleaded gas, while going into spring, again other things equal, unleaded gas will likely outperform crude or heating out.

In the arena of currency trading, the prevailing wisdom seems to be that only currencies issued by Central Banks count as currency. Specie, or what used to be known as hard money, apparently does not make the grade.

Thus Rubin, Buffett and many others have implemented their US$ bearish trades by selling the US$ index, or by selling $s against other currencies, like the Euro or Yen. Thus we have what Brad Setser calls the Club of Puzzled Dollar Bears.

One reason behind this restricted choice is the lack of liquidity in the Gold or Silver market compared to the currency markets. Speculators can sell a few billion $s without moving the relevant exchange rate much, while a purchase of $1Bil of Gold (50 short tons) would certainly move the $ Gold exchange rate. Ironically, the significant difference in liquidity between the paper money and specie markets seems to me a very good reason to buy specie.

Who knew the authors of the Gospels had insight into currency trading: Enter through the narrow gate. For wide is the gate and broad is the road that leads to destruction, and many enter through it.

Another factor arguing against the paper currency denomination of the short $ trade is the unwillingness to let the US adopt a "begger thy neighbor" policy a la the Plaza Accord when the rest of the world allowed the US$ to fall. The Chinese, to single out one nation, seem unwilling to take the same hit the Japanese took during the late 80s.

As a practical matter, this theoretical view has supporting empirical evidence. While the US$ has retained surprising strength vs. other currencies since Rubin and Buffett went short, it has fallen significantly vs. specie. According to Warren Buffett's wonderful annual letter to shareholders, Berkshire Hathaway began shorting the US$ in 2002.

Gold was trading at less than $350/oz during the whole of 2002, while Silver was changing hands at less than $5/oz. Meanwhile the USDX was falling from 120 to 103, the Yen (IMM) was rising from .75 to .875 and the Euro was rising from .86 to 1.04. Even if one assumes that Mr. Buffett picked the best entry points over the course of 2002 in the FX markets (120 in the USDX, .75 in the Yen and .86 in the Euro) the returns for the specie denominated short $ trade at current prices (Gold up 79%, Silver up 151%) far exceed even the best executed paper money denominated $ short trade (USDX down 28%, Yen up 13% and Euro up 48%). If the same trades were put on in 2004, the differences in returns are even larger (Gold up 49%, Silver up 78%) relative to the paper money markets (USDX down 4%, Yen down 7.6%, and Euro up 5% assuming an early year entry).

All of which is to argue, if you want to short the US$, buy specie or you risk joining the club of puzzled $ bears.