Opinion: Speak softly and carry a big stick

The Obama Administration is following Theodore Roosevelt's famous phrase when outlining its plans in dealing with the issue of currency intervention throughout the developing world. On the one hand Treasury Secretary Timothy Geithner has stepped back his rhetoric and criticism of China. Lately he had been speaking more softly. On the other hand the Federal Reserve has been waving a big stick in the form of limitless quantitative easing.

After a number of years of diplomatic pleading with China to allow the Yuan to appreciate, the U.S. seems finally ready to do something about it. When a cast of countries is intent on buying the U.S. dollar and thus as a by-product, create a global imbalance there are a number of things you can do. You can use diplomacy; that has been exhausted. You can cut rates dramatically; that has been exhausted. Finally you can weaken your currency to an equilibrium rate at which point the opportunity cost of not buying the dollar outweighs the actual cost. The way you do this is through quantitative easing.

Much has been said in the media concerning quantitative easing with regards to its effect on the domestic economy. We agree with the assessment that it does very little in the short term.

However, in the global economy it weakens the dollar, thus making U.S. exports more competitive; and as a byproduct it lessens the dollar's attractiveness to global foreign exchange reserve managers.
China has already noted that it is prudent not to hold all your reserves in one currency as that currency could devalue, thus altering significantly your reserves portfolio.

We believe the strategy being waged by the U.S. will have a significant effect on the G20 decision-making this weekend and in November. We have assigned a 50 percent probability to there being a framework agreed upon by G20 that will follow an agreed-upon path for developing countries to follow in allowing their currencies to appreciate lock-step with one another.

China's concerns over a one time re-valuation will be duly noted by the G20, and will likely be respected. Additionally, China wants to appreciate the Yuan over time will also likely be noted, and be the basis of the agreement/accord.

Going into the G20 meetings we expect a further 1-2 percent appreciation of the Yuan relative to the dollar, this will see the Dollar Index drop to new lows, and target the 70 level by the end of 2010.

With yield differentials between the U.S. and Europe now suggesting a EUR/USD rate of around 1.4250, and our expected move in the Dollar Index, we continue to be confident in our view that 1.5000 will be seen in the EUR/USD by the end of the fourth quarter 2010.

With the U.S. administration speaking softly and carrying a big stick, intervening nations with solid trade surpluses and growth had best take notice.

Douglas C. Borthwick is the managing director of Faros Trading in Stamford, Conn.

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