Bad Week? Not Here

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Despite central banks' best efforts, foreign-exchange specialist John Taylor of FX Concepts thinks the euro is headed sharply lower and the dollar will gain.
John Taylor believes that Greece is going to default, that the euro will fall, and that the U.S. dollar's rebound has just started. It was his kind of week last week.

Taylor's views have weight, because he runs FX Concepts. At $8.5 billion, it's not just the biggest independent currency-based hedge-fund firm on earth. FX also boasts a solid long-term performance record. Taylor's FX Global Currency Program earned 12.5% in 2010, topping the Barclay Hedge Fund Index by about two percentage points; it's sported a 9.3% annualized gain over the past 10 years through June 30. (In one of his down years, however—2009—the fund lost 17.9%.)

Taylor isn't afraid to run against the crowd. In April, he made headlines when he predicted that the U.S. was going into another recession, since growth seemed to be slowing and the Federal Reserve didn't have many ways left to revive it. A few months later, he began shorting the euro, because the Continent's sovereign-debt crisis was persisting, and began publicizing his bet that the dollar would be a beneficiary. Despite the Fed's so-called Operation Twist program to spur the U.S. economy, and efforts by the world's biggest central banks and finance ministries to stave off Europe's debt woes, Taylor isn't persuaded: "I don't know how the Fed isn't out of gas already. All they have left is the bully pulpit."

Greece's default is more a matter of when than if, he says, as the Greek citizenry won't support the austerity measures necessary to stay in the euro zone. There will be a referendum this autumn on some of the recent changes, and the outcome could upend the fiscal cuts already decided upon, Taylor warns.

So why should the U.S. dollar appreciate in such a horrid environment? As the world's reserve currency, Taylor says, the dollar has become a reverse indicator of the globe's economic health. "Whenever things are good in the world, [the] currency goes down," since there's ample liquidity. But when the rest of the globe is doing poorly, there's no liquidity and therefore the U.S. dollar is worth more. "That is the most important thing to know about foreign exchange nowadays–it is kind of backwards," he says.

TAYLOR, 68, GOT HIS START at Chemical Bank. He went on to First National Bank of Chicago, where he came to know some of that city's legendary traders and became familiar with trend-following techniques. He later worked for Citibank in New York as head of foreign-currency research, as well as for George Herrdum, a well-known mathematician and software guru who studied pricing cycles.

In 1981, Taylor went out on his own as a currency forecaster and consultant, and founded FX Concepts. In 1987, he started taking outside money. Success followed, as he relied on models that used both cycle and trend analysis to plot pricing patterns. He's applied his models not only to foreign-exchange, but also to interest rates, options and volatility; one year, he personally earned $250 million after his fund made a hugely profitable interest-rate bet. FX also has a global macro fund.

Among Taylor's influences is the 1991 book, Generations, by historians William Strauss and Neil Howe, which identifies longer-term cultural and demographic cycles in American life. "Every 80 years, we go through a deleveraging cycle," he says. "It's hard to measure, but that's where we are now. It has to do with the period 2010-20, compared with 1930-40." The so-called Millennials, who were born between 1980 and 2000, "will be the ones to save us, but they'll have no money, no entitlements," says Taylor.

Unlike a lot of traders, Taylor did well in last week's tumult. FX Concept's biggest position was in the dollar, but his trading desk was also short equities and positioned to benefit from a decline in long-term Treasury yields. He notes, "We were nervous" about what the Fed would announce after its two-day meeting last week, but by late Wednesday, FX Concepts had "piled in," building up a lot of its existing positions. "We are now aggressively long dollars, and short the euro," he says. Thursday, the euro slumped to its lowest level against the dollar since January, falling to $1.34, down from $1.36 late Wednesday. The dollar index, which measures the U.S. currency against a basket of six others, rose to 78.455, according to Bloomberg.

Late Thursday, Taylor told Barron's he now sees the euro trading between $1.37 and $1 over the next 18 months—nearer to the top side "if the Fed does its best at ruining our currency, and the euro manages to survive somehow." The world is pretending the European debt crisis is fixed, he adds—necessary if you are trading short term, but "long-term, a debt deal isn't going to work. The euro is going to hell. Every time they do things to fix it, it gets deeper and deeper."

Although he adheres a lot to models, Taylor, who studied political science before switching to finance, also does pay attention to Washington. When he watched the Republicans sweep the 2010 Congressional elections, he says he "knew we were headed for a recession." The GOP, which he thinks will win the White House in 2012, doesn't "want to print any more bucks." That will hurt the rest of the world, but it will make the dollar more valuable. So far, Taylor has had the U.S. economy's direction right: it's plugged along at about a 2% rate in 2011.

Taylor concedes that he's gotten the Fed's policies wrong in the past, and has paid a price. He assumed the dollar would strengthen in 2009, but the central bank instead flooded the markets with liquidity. His long dollar bet went against him, causing him a down year.

Are there any other currencies worth paying attention to? Taylor is positive on the commodity-based ones, such as the Australian and New Zealand dollars, despite their run-up. "We use commodities to forecast currencies," he notes. For instance, Norway's krone is a function of the price of oil, which he thinks is a solid long-term bet on the next growth cycle. In five years, he says, "we could see oil at $500 a barrel. I would be a buyer on dips of oil." But that's a trade for another week.