Some Auto Thoughts and Possible Dollar Implications

The seemingly inevitable bankruptcy of General Motors talk of the markets but it seems that the speed at which Chrylser is moving through its bankruptcy proceedings is remarkable. It may emerge from bankruptcy within the next couple of weeks, according to some press reports. This in turn spurs hope that GM, while significantly larger, may also emerge from a restructuring bankruptcy (rather than a liquidation bankruptcy) relatively quickly. The dollar impact is far from clear. Surely the gains it is posting on the session have little to do with the developments in the auto sector. It seems that what many Americans and critics lost during the crisis is an appreciation for the flexibility of the US--and this is not simply limited to the labor market. The economic contraction in the US is thus far significantly less deep than in most of continental Europe and Japan. And its fiscal measures, even allowing for different social safety net commitments, is much greater. In recent years the US specialized in finance, housing and autos. The ability of the US to redeploy resources, as socially disruptive as it may be, and develop new specializations appears unmatched elsewhere.

US April Existing Home Sales Preview

The US will report April existing home sales tomorrow. Surveys by news wires expect a rise of around 2% following the 3% decline in March. Yet the market may still be a bit more optimistic than the data. Recall that the April housing starts and permits data disappointed and the March CaseShiller headline also was worse than expected. That said, in both reports, some details were not as bad as the headline would suggest. Existing home sales in the US has been saw-tooth, rising one month only to fall the next month. This pattern of alternating advances and declines goes back to Nov of last year. March was a down number, so if the pattern remains intact, April will be an up number. But the risk is that the up number is disappointingly small. Existing home sales have not risen in the month of April since 2005.

Kohn Says Fed Purchases May Have Kept Rates Down 100 bp

This past Saturday the Fed's Vice Chairman Donald Kohn spoke on a panel at Princeton University. Kohn is also the most experienced person on the FOMC and he also headed up the working committee to help improve the FOMC communication. What he says is particularly important.

BOJ to Accept Foreign Sovereign Bonds as Collateral

Earlier today the Bank of Japan indicated that it will accept government bonds of the other G5 countries (US, UK, Germany and France) as collateral for their money market operations.

The immediate reaction was that this will help enhance liquidity conditions on ideas that Japanese banks will be able to use their foreign bond holdings as collateral. However, the Japanese branches of foreign banks also seem likely to benefit from the new collateral rules. Some foreign institutions, according to press reports, have faced difficulty raising yen and some have reduced their investment assets in Japan as a consequence.

Questioning the Dollar

In the near-term, the stars are aligned against the US dollar. Sentiment is decidedly negative. If the news stream is good, we are told investors are less risk averse and do not need the dollar’s security. If the news stream is poor, we are told the US is in horrific shape and the budget deficit and Fed’s balance sheet will swell even more.

It is difficult to see what will break this psychology in the coming weeks. The euro could rise toward $1.4600-$1.4800, with sterling headed toward the mid-$1.60s. The dollar also looks poised to fall into the low JPY90 or high JPY80s.

Sterling Resilience Trumps S&P Outlook Cut

Sterling fell around two cents in response to the S&P cut in the UK's sovereign outlook from stable to negative due to its rising debt as a percentage of GDP. However, the real take away does not seem to be sterling's hit, but its relatively quick recovery. Consistent with the other major European currencies, the pullbacks have been brief and mostly shallow, suggest the upside remains the path of least resistance. Sterling held support near $1.55, which is just above the 5 day moving average (~$1.5491), which has buoyed sterling in recent days.

Meaning of Price Action

The dollar has been thumped here today. There does not appear to be a key event. The drop in the dollar appears to be more a type of capitulation. Many, like ourselves have expected a pullback in foreign currencies, but the pullbacks have been shallow, as have been the dips in the equity market. The price action alone forced various market participants to sell dollars or risk missing the move.

Canadian Dollar Driver: Commodities or Interest Rates?

The Canadian dollar made new highs for the year a week ago and has been consolidating since. Yesterday's US dollar bounce carried it through the first technical corrective target near CAD1.1780 initially, but then fell through the pre-weekend lows to record an outside down day and there has been follow through today. Look for a near-term retest on last week's lows near CAD1.1477.

China/Brazil to Ditch US Dollar: Hardly

Brazil's state visit to China has set the chins wagging. Will an agreement be struck to invoice their bilateral trade in their own currencies rather than the dollar ? Brazilian President Lula had made some allusions to this last month around the G20 meeting.

Brazil to China: Show us the Money

Brazilian President Lula is in China today hoping to secure new investment commitments. Many observers appear to have mistaken verbal commitments with actual funds, but Brazilian officials don't. In 2005, many cited China's $7 bln investment pledge to Brazil as a sign of the expansion of the PRC's influence and its help to developing countries. Yet Brazil reckons of that $7 bln commitment, just a little more than $141 mln has been delivered.

Copper and Currencies

Copper prices were among the first of the industrial raw materials to bottom. Some investors and economists regard copper as a leading economic indicator even though they are aware of the increase role for fiber optic cables and other substitutes for what some call "red gold". Copper's low was set on Xmas eve and since then has been on a tear, appreciating 77%.

ECB: The Platypus Central Bank

If it looks like a duck, walks like a duck, and quacks like a duck, it must be a duck. Yet the European Central Bank says it is not a duck. Perhaps it is a platypus.

At its most basic level, quantitative easing refers to central banks using tools other than interest rates to make monetary conditions more accommodative. The ECB has expanded its balance sheet from €1157.53 billion in the summer of 2007 to €2088.87 billon at the start of this year. It has provided unlimited funding to its banks for six months with liberal collateral rules. Last week, it announced it will expand the duration of unlimited funding to twelve months. It also indicated then that there was an agreement in principle to buy € 60 billion euros of covered bonds.

ECB Says No to CEE Bonds as Collateral

The ECB may have agreed in principle to purchase covered bonds, but it has no appetite to accept local currency sovereign bonds from eastern and central Europe as collateral. Reuters reports that the ECB has formally rejected the request of “several” central European central banks to accept non-eurozone local currency bonds for collateral. The Deputy Governor Hungary’s central bank was quoted inidcating that the ECB notified them by letter today that the ECB “does not wish to expand the list of instruments accepted as collateral”.

What's Up (Down) with Libor?

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The benchmark three-month LIBOR continues to fall. Since last Friday, it has fallen by about 8 bp, more than in the whole month of March. In April, three-month libor fell about 20 bp and thus far this month it has fallen another 16 and counting. The LIBOR-OIS spread has also fallen sharply. It fell 9 bp today to bring this week's decline to 17 bp, after declining only about 5 bp last week. This closely followed spread (.uslibois on bloomberg) is now a little above 57 bp the lowest in nearly more than a year. It had averaged above 11 bp, according to Bloomberg data, in the five years before the financial crisis.

Shifting Drivers in FX

We keep a watchful eye on correlations between various currencies and othermarkets, including equities, commodities, and Treasuries. Although it may feel like some of these inter-market relationships are breaking down, a review of some recent correlations suggest otherwise. Believing it is the most rigorous approach, these correlations are run on percent changes.

Disappointing U.S. Retain Sales Did to MXN What S&P Failed to Do

The Mexican peso is under pressure following the disappointing US retail sales. The US dollar is at its best level against the peso since May 4th when the anxiety over the swine flu broke. The central bank meets at the end of the of the week and a large rate cut is likely.

Bipartisan Support in US Congress to Play with Fire

Washington contacts report that there is a bipartisan group in the Congress that is attempting to resurrect legislation that would punish China for not appreciating the yuan faster.

The Democrat Senator from Michigan (Stabenow) and the Republican Senator from Kentucky (Bunning) are leading the move in the upper chamber. They will reportedly meet tomorrow with members from the House of Representative, labor leaders and some business representative to discuss their proposal, tellingly, after its introduction.

Playing With Fire

Old men should know that playing with fire is dangerous. Yet that is precisely what they have done. Many have argued that the large US external imbalance was a major risk to the world economy. The previous solution was for the US to boost domestic savings, for Europe and Japan to make structural reforms to boost domestic demand, and for Asia to adopt more flexible capital markets. The lack of political will to implement the strategy led to the more expedient course of signaling that the currency market should be a greater burden of the adjustment and that in turn has sparked a near free fall in the US dollar.

Officials warned that the US trade deficit is not sustainable and that it injects unnecessary into the capital markets, which distorts investment and economic decision making. But the real disruption to the capital markets, with potential negative impact on world growth has been the clumsy attempt by the G7/IMF trying to fix the problem. Global equity markets have sold off. The rise of global interest rates has accelerated. With a sharply falling dollar, the ability to smoothly finance the US current account deficit is called in to question as the lukewarm reception to the Treasury’s recent auctions indirect bidders. The cure seems worse than the disease.

Although a number of officials, including from the ECB’s Trichet, the Fed’s Bernanke, and at least two senior MOF officials from Japan, indicated the G7 did not signal a general dollar sell-off, the market suspects otherwise and understands those comments as half-hearted attempts to maintain an orderly market. Thus far the absence of clear, strongly worded protests to the pace or magnitude of moves in the foreign exchange market is understood by many participants as acquiescence at the very least and possibly even sanctioned. While the euro was motoring ahead, at least two ECB officials indicated without apparently much prompting that more aggressive rate hikes might be needed. The comments seemed to reflect the lack of concern about the euro’s appreciation.

Been There Done That

Political considerations had seemed to argue against a new G7 policy initiative. The governments in Germany, Italy and Canada are new. Japan’s Koizumi is expected to step down in the fall and a new head of the Finance Ministry is likely. Many people suspect that UK Prime Minister Blair may step down before the end of the year as well. The French government is unpopular and there is talk that President Chirac may reshuffle his government to bolster the party’s chances for next year’s election. In the US, there continues to be speculation that Treasury Secretary Snow’s may be replaced shortly. One of the people rumored to be a likely candidate is Harvard’s Martin Feldstein. Although news wires report that senior US Treasury officials have in both public and private requested officials refrain from not only material intervention by verbal commentary as well.

Yet rather than prevent a new initiative, the political weakness of the individual G7 countries has led to a reversion to an earlier and politically expedient strategy: in lieu of the political will for implementing structural reforms, let the currency market bear the adjustment. In effect, the US had abandoned the strong dollar policy, first articulated by Robert Rubin to signal a break from the devaluationist thrust of his predecessor Lloyd Bentsen.

Many observers have portrayed the G7/IMF stance as multilateral. This is deceiving. There have been two other meeting in recent weeks of monetary officials (ASEAN+3 in early May and the Asian and European finance ministers met in late April) and the statements that were issued did not reflect the sense of urgency of the G7/IMF meeting communiqué and the key difference was the absence of the US.

Also, consider that after the 1997-1998 Asian financial crisis, insofar as the IMF essentially pushed for the implementations of the Washington Consensus, it is hardly perceived as an independent actor. US foreign economic policy is a sub-set of US foreign policy. This is another “coalition of the willing”. In addition, while there is official recognition that the voting system of the IMF no longer reflects economic reality and reforms are likely to announced in September, it did not prevent the old IMF in which developing countries, including China, India, South Korea, Brazil and Russia are not fairly represented from taking on a new foreign exchange mandate.

We have been down this road before. The pattern is for European and Japanese officials to “cry uncle” before the US and long before the dollar has fallen to levels that the conventional view says is required to correct global imbalances. With the US Congress approving the renewal of some the Bush Administration tax cuts, the signal being sent is that the US may not be serious about boosting savings and will rely on currency depreciation. As the euro near the psychologically important $1.30 level and the dollar spends more time below JPY110 and global equity and bond markets become more volatile, it will not take long for domestic pressure to build and resistance to dollar depreciation to grow

Politically Expedient but Maybe not Effective

If dollar depreciation would work to reduce the global imbalances, it would arguably be acceptable. However, the problem is that, looking at the actually track-record, rather the sophomoric economic theory, there is little evidence that a decline in the dollar would achieve the goal. The US dollar peaked against the Canadian dollar in 2002. The Canadian dollar has appreciated by about 50% in the past 4-years, which is what some of the more extreme estimates suggest the Chinese currency is undervalued by. The average monthly US trade deficit with Canada has risen from about $4 bln in 2002 to about $6.7 bln. The four years that have passed should be enough to offset the “J-curve” effect that economists speak of to account for a lag between changes in the price of financial variables and changes goods prices.

This experience is not limited to Canada, the US’s biggest trading partner.

Consider Europe. The euro recorded its historic low against the dollar in 2000 near $0.8230. It too has appreciated by 50%+ against the US dollar. The US recorded an average monthly trade deficit with Europe of roughly $5 bln in 2000 and 2001. It stands at $10.4 bln now.

What about Japan ? The dollar’s has been recording low highs against the yen for nearly 20-years. The last major high was in 1998 near JPY147.50. The peak in 2002 was near JPY135. In 1998, the average US monthly bilateral trade deficit was about $5.3 bln. Now the monthly average is closer to $7 bln.

Given that policy makers cannot be sure that even if the Chinese currency appreciates against the US dollar that the bilateral imbalance will improve, the risks of the current strategy seem greater than likely rewards. Sure nearly every one agrees that the US external imbalance is not sustainable, the sense of urgency does not seem justified. There are more urgent issues, for which Chinese cooperation is more critical and with a higher probability of success. Such issues would include Iran, North Korea, Taiwan, the regional arms race and environmental issues.

Feel Mush, Push

In sword fighting, it is said, when you feel mush push; feel steel, retreat. The dollar feels like mush and the market is pushing. While technical indicators and short-term speculative positioning are at extreme levels, warning that a technical correction may be in the offing, until the official pain threshold is reached, the dollar bears will remain in control.

Support for the euro is seen near $1.2830 and $1.2750. Many investment banks have revised down their dollar forecasts based on the recent price action and many are now looking for a test on the $1.30 level. As more observers recognize that the US has abandoned the strong dollar policy in everything but the exact words, the risk is that the euro tests its record high near $1.3660 this year. The dollar faces important resistance near JPY112.00 and while the JPY109 may now offer support, the real objective is closer to JPY105-JPY106.

The dollar’s depreciation is tantamount to a partial default. The risk is that officials will find it increasingly difficult to arrest the greenback’s decline as this becomes more evident. In a world of fiat currencies, confidence in officials is a critically salient factor. Confidence in the US Administration is on shaky ground at best at the moment and it does not seem to realize it.

The combination of low volatility, low interest rates in the advanced industrial countries, plenty of global liquidity and rising commodity markets has fueled a multi-year rally in many emerging markets. These conditions, except commodity prices, have changed. The risk is for a larger unwinding of emerging market investments. Investors in the emerging markets could be among those burned when old men play with fire.

Covered Bonds: Back to the Future

The European Central Bank seems to surprise the market once a year. Last July the ECB surprised the market and arguably common sense when it hiked interest rates at the peak in commodities, especially oil, just as the region’s economy and other major industrialized economies were about to fall off a cliff. It appears to have gotten this year’s surprise out of the way with its May 7th decision to purchase covered bonds.

US Inflation: Where and When

There are two main issues that are worrying investors. The first is the future of the dollar as the numeraire—the key metric in the world economy. Recent Special FX pieces have argued that this concern is misplaced. The dollar’s share of reported reserves remains fairly stable. Its use as an invoicing currency remains pervasive. Numerous commodities, including oil, foodstuffs and fibers, industrial goods, and even a wide range of raw materials, continue to be priced in dollars. We have looked at alternatives to the dollar, such as the IMF’s Special Drawing Rights (SDRs) and gold and have found them wanting. Looking at the actions of the vast majority of countries, (yes, ignoring the rhetoric), the inescapable conclusion is that the dollar’s role remains secure.