Dollar Bull Case Updated

Last week we outlined a bullish case for the US dollar. It was predicated on US economic data confirming that the soft Q4 05 GDP was a fluke and that the economy was off to a sufficiently robust start of the year to absorb more the diminishing slack in the economy. This in turn would compel the market to re-think the likely trajectory of Fed tightening, interest rate differentials would widen and the dollar would strengthen. This is largely what happened over the past week and there is reason to expect additional dollar gains in the period ahead.

Fundamental Review

As had been widely expected the Federal Reserve raised its Fed funds target by 25 basis points to 4.50% on January 31, Alan Greenspan’s last meeting. The statement issued afterward to explain the rate hike was crafted in such a way as to maximize the new chairman’s degrees of freedom. The controversial “measured pace” commitment was finally dropped after long debate and other language was softened, with further tightening “likely” to “may be needed.”

Given the underlying need for the Fed to be as non-committal as reasonably possible, the wording of the statement did deter the market from continuing to raise the odds of a rate hike at the March 28th FOMC meeting. The market now assesses the odds of a quarter point hike in March around 90%, up from about 50% as recently as two week ago.

But there is more. An even more pronounced swing in the pendulum of market sentiment is taking place further out. Specifically, the July Fed funds futures contract, which given that the June FOMC meeting is late in the month offers useful insight into expectations for Q2. The July contract has sold off 11.5 ticks this week and 20 bp in the past two weeks. The market is now discounting a 60% chance of June hike or 5.00% Fed funds by mid-year.

Déjà vu All Over Again

Nor was this new appreciation for the likely duration and magnitude of the trajectory of Fed policy adversely impacted by the disappointing headline non-farm payroll growth. It was almost a repeat of the market’s reaction to the disappointing Q4 GDP report. The market quickly saw past the superficial weakness and focused on the underlying strength. Not only were back month employment reports revised up (by a cumulative 81k), but the unemployment rate slipped to 4.7% from 4.9% to stand at its lowest rate since July 2001. Average hourly earnings rose 0.4% for a 3.3% year-over-year pace, its strongest since February 2003.

The decline in the unemployment rate coupled with the rise in earnings is significant on two levels. First it speaks to the Feds’ continued concern about resource utilization rates. Clearly there is a lot less slack in the labor market than had been the case. Secondly, more people working for more money will support income and consumption and should help blunt some of the headwind generated by the softening of the housing market.

Admittedly some of ISM survey data was softer than expected, but still consistent with trend-like growth for the world’s largest economy. In fact, it would not be surprising to see Wall Street economists revise up their Q1 06 GDP guesstimates. The US economy appears to be expanding at an annualized rate of 4.5%-5.0% presently.

Interest Rate Differentials Shifting in US Favor

We have been monitoring the June 06 Euribor-June 06 Eurodollar spread as a proxy for short-term interest rate differentials. The spread had reached its widest point in the cycle last August near 220 basis points. As the market began pricing in ideas that the Fed was nearly done, but that the ECB had just begun to adjust rates, the spread narrowed. On January 3, the spread stood at 188 bp and as recently as January 25 was still below 200 bp. Following the Q4 GDP on January 27, the spread stood at 201 bp, and is at 212 as this essay is penned.

It is not just the short-end spread that has widened in the US favor. The spread between the US 2-year yield and the Germany 2-year yield widened out 11 basis points over the past week to 166 basis points. This is 21 bp wider than a month ago. The movement in the 10-year spread has not been as large, but the direction is clear. The 10-year US-German bond spread has widened 4 bp over the past week to stand a little over 105 basis points. Further widening is likely in the coming period with the spread likely moving, albeit gradually, toward the cyclical peak registered late last October near 122 bp.

The US yield curve, as measured by the spread between the 2 and 10-year notes, has become inverted and appears likely to sustain the inversion unlike the brief flirtation earlier last month. Over the past week the US 2-year yield has risen by 11 bp while the 10-year yield has risen by only 4 bp. That puts the 2-10 curve inversion at about 6 bp. Past periods of 2-10 inversion have coincided with US dollar gains.

On the Radar Screen

The only important US economic report next week is the trade (im)balance on February 10. The consensus calls for a modest widening of the deficit from $64.2 bln in November to $65.0 bln December. If the actual release differs markedly, it could impact expectations for revisions to Q4 05 GDP, but may not have much lasting impact on the US dollar.

Of all the data the US reports, the least understood is the trade and current account. First, many observers may not appreciate that more than a third of US imports and more than 30% of US exports are movement of goods within the same company. Intra-firm trade accounts for around half of the US trade deficit. When an auto maker imports parts from a subsidiary located say in Mexico or Canada, the US government reports this as part of the trade deficit when its really just moving goods from one side of the factory floor to the other and it just so happens that a national border runs through the factory.

Second, the US has difficulty making its accounts balance. For example, in the third quarter of 2005, the most current data, the US recorded $195.8 bln current account deficit. The plug factor or what the government euphemistically calls statistical discrepancy was a whopping $76.7 bln. This is the largest ever. One might expect that the discrepancy evens out over the course of an entire year. Not. For the year 2004 as a whole, as an example, the statistical discrepancy stood at $85.1 bln.

Third, and probably most importantly, we have to keep our eyes on the prize. Capital flows swamp trade flows by a huge margin. In the 19th and 20th century the US acted as a safety valve for Europe and to a lesser extent, Asia’s excess population. Later in the 20th century and to the present, the US absorbs the surplus populations of Latin America. Also starting after WWII, the US began absorbing the world’s excess production. Increasingly in the last quarter of a century the US now absorbs the world’s surplus savings, as the new Federal Reserve chairman has argued.

What this means is that the US is acting like the banker of the world. And it does so fairly successfully, one might add. Foe 2004, the most recent disaggregated data, the US paid about 3% on its foreign liabilities but received 4.2% on its foreign assets. This results not only because the US asset allocation is more heavily weighted toward equities than foreign investors preference for US fixed income products, but also the US companies achieve a better return that foreigners do on direct investment. In 2004, the US direct investment abroad generated a 9.8% return, while foreign direct investment in the US generated a return of 6.15%.

Specific Dollar Outlook

These fundamental arguments coupled with the technical condition of the market suggest potential for more dollar gains in the period ahead. The $1.21 area should now cap euro upticks. A convincing break now of $1.1960 is needed to signal the start of the next leg lower, with the $1.1900 area offering initial support but potential toward $1.1800. The dollar is likely to encounter offers near the 119.50 yen level, but a break above it, perhaps ahead of the first 30-year US Treasury bond auction in 5 years on February 9 could signal a climb toward the JPY121.40 area. Lastly, although sterling has held up a bit better than expected, the technical tone has weakened and sterling still looks headed toward $1.75 after having been rebuffed in the $1.78 area