USD Can and Will Drop

Recently there's been a wave of blogosphere opinion that USD is a win-win bet. It goes like this: if the world economy gets worse or stays in the dumps, then USD will remain strong, as demonstrated by its performance since Sept 08; if the world economy rebounds, then USD will of course be strong.

It is the "of course" part that I have a problem with. There're two scenarios under which USD will drop, and only one under which USD will remain strong in the intermediate term (a year or two). But even under the last scenario, USD is likely to drop in the longer term.

1. The world economy stabilizes. Make no mistake, we're not there yet. It won't happen until at least the clouds of CEE debt/currency crisis, US/European banking and credit crisis, housing price, unemployment, and consumer demand start to dissipate. But when that happens, the world will be shifting away from USD assets. Furthermore, it is very unlikely that the Fed has enough political will to siphon the massive amount of USD cash it will have printed off the system early enough and fast enough to pre-empt the surge of inflation once the economy stablizes and credit starts to flow again.

2. The world economy stays sickly for years. Under this scenario, the Fed would likely continue printing massive amount of moneyfor awhile. This would put other countries at a disadvantage since nobody else has this kind of monetary leverage. Therefore, they would be increasingly determined to seek alternative reserve currencies. True, right now there is no alternative. But I don't think it's wise to misunderestimate the world's determination and creativity when defending their own economic and strategic interests. When such alternatives emerge, a big part of the world would not feel sorry to abandon USD, a once safe asset abused and discredited by the Fed and US government.

3. As I mentioned above, there're still numerous cloud overhangs. We are quite likely yet to encounter a few more trigger events. Under this scenario, USD would strengthen. But there's a limit to how long the perception of USD being the safe harbor can last. If the crisis mode continues for another year or two, the world would increasingly re-examine the assumption and seek alternatives.

In particular, I find the assumption that China will remain contend sitting in the USD trap laughably arrogant, short-sighted, and lacking imagination. It may happen in the end. But don't take it for granted.It'd take a fundamental shift in US' China policy for China to stop trying getting out of the trap. So far they've talked about SDR, arranged a sleuth of bilateral currency swaps, and piled up on gold. None of the approaches is the end solution. But it'd be foolish not to take their effort seriously.

I've been long USD (against EUR and JPY), gold and TIPS since the beginning of the year. I remain comfortable with all three right now. I trade the intermediate time horizon, from weeks to months. But I'll be ready to flip USD in short order going forward. Against what I don't know yet. We'll find out. But with the wave of opinion of USD win-win bet, I suspect we'll find out soon.