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Multi-manager View

Albeit battered and bruised, the US dollar is still the reserve currency of the world and the two most important prices for financial markets remain US interest rates and the dollar exchange rate.

The Federal Reserve has been manipulating both prices lower for much of the past decade. Today, with interest rates effectively at zero, the latest iteration of this policy has been accomplished through quantitative easing.

Market participants are up and dancing like it is the summer of 2007 but investors must understand that when the two most important prices upon which almost every asset is valued are artificially suppressed, the implications are widespread and risky.

Over the past decade, we have got used to a weak dollar being positive for risk appetite and asset prices. Since 2002, when the Fed took real interest rates to abnormally low levels, the dollar has hit record lows. We have since undergone a resources boom in the Asian dollar bloc and commodity prices have moved sharply to the upside as a result.

Bond yields are higher/ prices lower (not by design but tolerable), equities are higher (by design) and inflation expectations have moved up with food and energy prices.

It is to this last point where we question the sustainability of Fed policy and the likelihood of a third round of QE. More than 22 per cent of US incomes now go on food and energy bills. We have only ever seen this twice in the last 20 years and both times the economy fell into recession.

Overseas, where food and energy form a larger part of disposable income, inflation is accelerating with sufficient voracity that central banks are tightening policy. In Europe, pressure is building for rates to move higher. Can the Fed continue to ease policy against this backdrop? The benchmark for further easing appears to be high and rising.

Nonetheless, markets seem comfortable with QE3 and the pro-QE3 momentum trades (short dollars and long everything else) look crowded.

We have used this opp-ortunity to take the opposite side of current consensus and have increased our dollar exposure by buying the currency directly and also hedging a degree of our yen exposure into dollars.

At the end of the 1970s, after a decade of abnormally low rates and a weak dollar, Fed policy changed dramatically. The dollar spent the best part of the next 20 years going up and this coincided with the longest period of economic expansion in US history.

The world today faces different challenges from 30 years ago but we cannot help but think the world would benefit at this stage from a strengthening dollar.

Robin McDonald is co-manager of the Cazenove Capital multi-manager range of funds


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