The Bull Case for the Dollar

The disappointing Q4 2005 US GDP report and the subsequent dollar decline is unlikely to have a lasting impact on the market. In fact, there are good reasons to expect the US dollar to strengthen in the days ahead.

The 1.1% pace of growth in Q4 2005 was the slowest since Q1 03 and breaks the string of 10 consecutive quarters of 3%+ growth. Nevertheless, early indications suggest the US economy has likely rebounded and when considering the outlook for the Federal Reserve and the dollar, this outlook is more important that the Q4 disappointment.

Hot and Cold Money

There may be a general misunderstanding about two issues regarding capital mobility that emerged this week. The first involves how East Asia is coping with the deluge of foreign investment flowing into the region’s equity markets. The second is the apparent Iranian decision to move their investments out of Europe for fear that if sanctions are implemented, the funds could be frozen.

Foreign investors have flocked to East Asia and their buying helped fuel sharp gains in most of the regional bourses until this week. The foreign inflows have tended to push up regional currencies and expand monetary conditions, even though several central banks in the region are in a tightening mode. Since China’s currency regime changed six months ago on 21 July 2005, most currencies in the region have appreciated and by much more than the 0.6% that the yuan has advanced.

Two New Currency Products

The foreign exchange market is primarily an over-the-counter market. The $2 trillion a day market is conducted primarily over telephone and computer lines, with banks still the primarily market makers. However, anecdotal reports suggest that there has been a surge of interest in the foreign exchange market over the past couple of years. Due to the relative low entry barriers, high leveraging ability, and an intensified search for greater diversification amid global capital markets have become more integrated and arguably increasingly correlated, there appears to have been a dramatic increase in smaller participants in the foreign exchange market, especially hedge funds and commodity trading advisors. In recent weeks, two new exchange traded currency products have been launched.

The View From 10,000 Feet

The New Year has begun with a bang. Global equities have rallied. Bond markets have generally firmed. The dollar has slipped against most of the major currencies and regional Asian currencies. Emerging market currencies in general are off to a good start, led by the South African rand (+~5%) and the Brazilian real (+~3%).

Corporate Bond Offerings: A Source of Dollar Demand in 2006

We have generally played down the significance of the tax holiday given to US corporations for repatriating offshore earnings in explaining the US dollar’s rally in 2005. For a number of risk-management reasons, US companies tend to keep the vast majority of their overseas earnings in dollar-denominated instruments. Nevertheless, because the law is based on a company’s fiscal year and not the calendar year, there could still be some repatriaiton in the first part of 2006. However, there is likely to be another source of demand for dollars and that is likely to come from a flood of new debt issuance by US companies.