Making Cents of the Dollar

There is modest run on the US dollar in underway. Over the past month, the greenback has lost nearly 5.5% against the New Zealand dollar, 4% against the Australian dollar, 3% against the Canadian dollar, more than 2% against sterling and the euro. By contrast, the yen has under-performed, losing more than 1% against the dollar. The dollar appears to be becoming under valued, but the risk is that valuations get stretched even further before snapping back.

There are several forces at work behind and driving the price action. It is important to recognize that these forces are not all dollar negative but rather positive for the other currencies. The stream of economic news from Australia, New Zealand, the euro-zone, the UK, Sweden, and Norway all point to the likelihood of additional near-term rate hikes. The economies are generally robust and there are threats to price stability.

Sterling’s rise through the $2.00 mark was sparked by a higher than expected CPI report, which at over 1 percentage point above the 2% target required BOE Governor King to write a letter to the Chancellor of the Exchequer and Prime Minister Blair’s heir apparent explaining the overshoot and reaffirming the BOE’s commitment to the inflation target.

As reflected by indicative pricing in the futures market, the expectations have been in place for some time, but what has changed is the market’s confidence of these rate hikes and the growing suspicions that these rate hikes anticipated in the coming weeks will not signal the end of the tightening cycle, which is now anticipated to extend into Q3.

This is taking place amidst ideas, as reflected in the Fed funds and Eurodollar dollar futures, that the Federal Reserve may cut rates in the third quarter. The narrowing of interest rate differentials acts as a corrosive force on the dollar. The Euribor-Eurodollar futures spread has been fairly stable lately, but going slightly out on the curve shows a different story. Over the past 5 days, the 2-year spreads narrowed by about 8 bp to less than 50 bp. This move is greater than the narrowing that had taken place in the previous three weeks.

A similar pattern is evident in the 10-year sector. The 10-year spread between the US and Germany narrowed 5 bp over the past five sessions and at about 50 bp stands at the narrowest in nearly three years. This decline matches the magnitude of decline of the previous three weeks.

That the narrowing of interest rate differentials is an important operative influence, overriding trade deficits, is reflected in the continuing strength of the Australian and New Zealand dollars, both of which record significant current account deficits that rival the US deficit as a percentage of GDP. Compared with the US 5.25% Fed funds target, the cash rate in New Zealand stands at 7.5% and Australia 6.25%. In effect, the yield pick-up in New Zealand is greater than the yield pick-up of buying the index of emerging market bonds that make up JP Morgan industry benchmark EMBI+ Index.

Another factor that has emboldened the dollar bears is the absence of official protest coming from the recent G7/IMF meetings. Even though officials acknowledged that the global imbalances have been reduced, they also seemed to endorse the current stance of the ECB, that more rate hikes may be needed to ensure price stability, and the BOJ which, with inflation pressures nearly non-existent, can be patient about increasing rates.

European finance ministers, who objected to the yen’s weakness in late February, were noticeably more circumspect most recently even though the yen is weaker now against the euro than it was then. Just as important, even with the euro near record highs against the US dollar, European finance officials, often to be counted on among the worry-warts, about the euro’s strength against the dollar, have also seemed to see the virtues of the recent gains, or in any event, are not troubled by it. In sword fighting, there is a saying that when one feels mush, push; feel steel, retreat. Right now the dollar feels like mush.

However, macro-economic fundamentals are not as poor in the United States as the dollar’s price action would suggest. The US slowdown probably bottomed in the first quarter. We are likely to learn next week (27 Apr) that the US economy expanded by a little less than 2% at an annualized rate in the Jan-Mar period, which would likely be the second consecutive quarter that the US grew slower than the euro-zone (May 15) and UK (Apr 25).

Some of the headwinds that have been restraining US growth appear to have lessened as the first quarter wound down. Two such headwinds stick out: housing and manufacturing. We learned in recent days that housing starts unexpectedly rose for the second consecutive month in March. When looking at activity in the housing market, it appears that the sub-prime sector is continuing to contract, but the more traditional part of the market appears to be stabilizing and perhaps improving in some places.

In terms of manufacturing, the market tended to put too much weight on the recent disappointing 0.2% decline in March industrial production. A weather-related decline in utility output dragged the headline rate down and obscured the more important fact: manufacturing output jumped 0.7%, more than in Jan and Feb put together.

Sentiment toward the US dollar remains poor, however, and this will likely dictate the near-term direction. Indeed psychology is very telling presently. The market is looking at the dollar glass has half-empty rather than half-full, ignoring favorable economic developments, like a 6-year low in unemployment, the rise in housing starts and strong rise in manufacturing output. The magnitude of the dollar’s loss over the past week has been quite modest,--less than 1% against sterling, about 0.5% against the euro, and less than 0.4% against the yen. But what has caught the imagination of the market and media are chart levels like $2.00 for sterling.

The euro reached a record high near $1.3665 on New Year’s Eve 2004. What makes it a record high, though is the euro’s short life. If we take the high of the old Deutschemark and convert it into euros, it would correspond to about $1.4500 for the euro. A retest on this level is possible, but at this juncture, it would seem to require a further deterioration of the US economy. Instead, a more modest target of $1.40 seems more likely in the coming period. This probably means that sterling can rise toward $2.06 before everything is said and done.

However, if the Federal Reserve is correct, which is our leaning, the US economy will recover in H2. We also expect that the impact of higher rates, tighter fiscal policy and currency strength will slow the European economies and provide the material basis for a dollar recovery. The risk is that as is its habit, the market is attributing structural factors to what are most likely cyclical forces. That once again the demise of the US dollar is being exaggerated. While the dollar bears still have life, their days are numbered.
Making Cents of the Dollar Making Cents of the Dollar Reviewed by magonomics on April 20, 2007 Rating: 5
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