CHICAGO (Futures Magazine) -- The U.S. dollar has declined deeply and except for a minor correction in 2005, consistently, since 2001. Its strength as measured by the U.S. dollar index, a basket of six major currencies developed in 1973, is at its weakest point ever after dropping to .7340 in early March.
The reasons are many: persistently low interest rates are probably the biggest cause, and the subprime lending crisis and resulting liquidity crunch have piled on. Now, lower consumer confidence resulting from evaporating home equity, softer employment numbers and a downturn in the business cycle, which prompted severe cuts in short-term interest rates, have taken the dollar to levels few even thought possible.
And the bad news keeps coming: the dollar dropped past $1.52 against the euro, crude oil is now trading at more than $100 per barrel, food prices are on the rise and The Institute for Supply Management manufacturing index declined in February to 48.3, indicating economic contraction. That being the case, any serious talk about a dollar recovery is being deferred to the second part of the year.
“The ECB [European Central Bank] revised their GDP forecast down to just a few tenths of a percentage point higher than the Fed,” says Kathy Lien, chief currency analyst for FXCM, indicating that growth in Europe also is slowing and that other central banks likely will eventually revise their forecasts down. “It has taken the focus away from yield and shifted their focus onto growth. And price action reflects the market’s belief that the U.S. will see a shallow downturn and a quick recovery.” But with futures markets already pricing in more cuts totaling 75 to 100 basis points, things will worsen for the U.S. dollar before they get better.
Comeback kid
In the case of a global economic slowdown, the United States could recover aggressively against the Euro zone, United Kingdom and Canada because it lowered rates sooner.
Prior to the ECB’s March 6 meeting, the assumption was that the European economies would be slowing, which would lead to dovish rhetoric and an eventual rate cut. “That didn’t happen,” says Joe Trevisani, chief currency analyst for FX Solutions, and the U.S. dollar, which has fallen 13% against the euro in six months, will likely continue weakening because of the Fed's unwillingness to support it, even rhetorically. “When the Fed chairman says the obvious, that a weak dollar fosters U.S. exports, currency traders hear not a description of a currently weak dollar, but a prescription for a much weaker dollar in the future,” he notes. And the ECB’s continuing hawkishness, especially in the face of ongoing wage negotiations in Germany , likely pushed any U.S. dollar recovery out another two months, Trevisani says. “The ECB did not have to give up the anti inflationary rhetoric and they haven’t done so.”
Economic growth for individual countries will be the deciding factor, Lien says. Australia and New Zealand have been sheltered by the commodity boom and China ’s double digit GDP growth, as have the Euro zone, United Kingdom and Canada . But weaker economic data is starting to come out of those countries, and both Canada and the United Kingdom have recently lowered interest rates. In addition, the ECB has also revised its forecast down to 1.8% GDP growth for 2008, almost a full percentage point less than the 2007 growth rate. Lien expects the ECB to cut rates by 50 to 75 basis points later in the year.
When that happens, the countries that have lost the most at the expense of the euro will have the most to gain, says Rob Booker, independent forex trader. “There is a point at which Europe has to cry ‘Uncle.’ And when Europe cries ‘Uncle,’ they are going to have to catch up with the rest of the world,” he adds. By May, he expects the dollar to trade between 146 and 147 against the euro. And he isn’t the only dollar optimist.
Marilyn McDonald, analyst for Interbank FX, says that she expects the dollar to gain on the euro to 144. “At some point, traders will say, ‘this is madness,’” and start to reverse.
Longer term, Andrew Wilkinson, analyst for Interactive Brokers, is slightly more optimistic and says the dollar will gain to 140 against the euro.
One way to gauge whether the U.S. economic recovery is proceeding is through the Treasury International Capital System (TICs data), a report from the U.S. Treasury that tracks money flowing into and out of the United States .
Booker explains that a proper recession in the United States could bring the equity bubble back down to earth and draw the interest of foreign firms, governments and investors. Those entities, rather than dumping downtrodden dollars, would more likely invest them in hard assets and buy more dollars to participate in the U.S. equities market.
Booker says that if the TICs data, which recently dropped to just above $50 billion, is not in the $70 billion to $100 billion range, it will indicate an insufficient demand for dollars and U.S. dollar denominated assets; and a sub $50 billion reading would indicate a more protracted recession.
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As the Fed lowers rates, the next thing to watch for will be whether the yield curve continues to steepen, wh ich has been a recent pattern, Wilki nson says (see “The great curve ”). “Regardless of whether the producer and consumer price pressures are sticky, or just slow to depart the scene, the market is now more concerned that the U.S. economy has an inflation problem going forward, which means that there are fears that whatever the Fed gives now, will be taken away quickly later this year.”
The shape of the two-year/10-year yield curve has recently moved out to 185 basis points, Wilkinson points out, and his concern is that as the Fed cuts short-term rates, they will have less impact on long-term rates. “Looking back at the shape of the yield curve, as the Fed eased aggressively following Sept. 11, 2001, the yield curve performed exactly the same way. The more the Fed eased, the steeper the curve became,” he says, due to the fear that the easing cycle would end and reverse.
To assure the transmission of easy money occurred, the treasury terminated the 30-year bond auctions and dried up the supply, Wilkinson explains. “That put a bid under the 10-year note and helped to flatten out the curve,” he says, adding that there is still plenty of steepening left for the curve to take before the situation became dire.
Cash and carry
Another emerging trend in the currency markets is the end of the carry trade as we know it, with the low yielding Japanese yen and Swiss franc serving as funding currencies. Booker explains that in order for the carry trade to work, interest rates must collectively be on the rise, but that we are entering an elongated period when interest rates are coming down.
“The conditions that foster the carry trade no longer exist,” Booker says. “We see a massive reversal in the carry trade. As firms realize that more and more, we see a cross rate in the GBP/JPY and the EUR/JPY that come much, much further down.”
As the world’s largest consumer economy, a U.S. economic slowdown could harm global demand and hurt the commodity dollars, which is already happening to the Canadian dollar.
Another commodity currency, the Australian dollar, has benefited greatly from its proximity to China , Japan , Korea and other Asian manufacturing countries. However, Wilkinson says it is not immune to a global economic slowdown. “In this event, investors will look for a sharp drop in Aussie rates, and that yield drop would quickly see the Australian premium unwind,” Wilkinson says. Inflation could be another complication. “Demand for energy has failed to rescind, and that’s the major cause of price pressure trickling its way through the economy. Bottom line is that not enough growth will fail to underpin the economies.”
McDonald expects the Asian economies to strengthen, and for the U.S. dollar to lose some strength to the yen. “Their economies are really robust, and they don’t have the same inflation fears that we have,” she says.
But China may not be immune to the global slowdown, Lien says. She expects to see inflation and rising unemployment in China , already 6.1% in non-urban areas, following the Olympics, causing the China bubble to pop. “When it pops in China , it is going to hurt all those countries whose growth has only been supported by Chinese demand. That’s when we are going to see re-coupling, and that means that we will see currencies like the pound, the euro and Australian dollar lose strength against the U.S. dollar.”
Another possibility is that the U.S. dollar could become a funding currency, McDonald says. “We have been a yielding currency forever, because our interest rates have been fairly high across the G-10. We fell to sixth a while back and now our interest rates are fairly low when you compare us to everyone else. We are at 3%, the Swiss is at 2.75%. The only thing lower than that is the yen. People are going to seriously start looking to the U.S. currency as a funding currency and playing that against the Australian, the New Zealand or even the pound, as a yielding currency,” she says (see “Th e new carry: Short USD” ).
“Whether the Americans are in recession is not the most important question. When the U.S. will recover is,” Trevisani says, add ing that only an improvement in the U.S. economy and a Fed rate hiatus would do that. Until then, he expects the euro will continue to creep higher and could hit $1.6000.
While many analysts are calling for the dollar to bottom, there is little fundamentally supporting it and calls for the euro to go to 140 are not exactly bullish the dollar. No one expected the U.S. dollar index would trade below 80 until it did. Then no one thought it could trade below 75. Currently the Fed has made clear that it will aggressively cut interest rates regardless of their impact on the dollar to support the economy, even while other industrialized countries battle inflation.
Much dollar support is coming from disbelief that it could drop as far as it has. “At the moment when they think that the dollar has been completely and utterly destroyed, they need to consider that the dollar is ready for a comeback,” Booker says.
© Futures Magazine, 2008. News, analysis and strategies for futures, options, forex and stock traders. Established in 1972, Futures magazine is the oldest and largest circulation publication serving the derivatives industry. Futures Magazine is a sister company to Resource Investor, and part of Summit Business Media, LLC.
