The Dollar: Short-Term Rebalancing Of Expectations, Long Term Risk
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Recent price action in the foreign exchange market in our estimation is a function of a short-term rebalancing in expectations of global growth and demand for commodities. When combined with the pause in the rate hike campaign at the European Central Bank and growing uncertainty regarding the prospects for economic growth in the United States dollar bulls that have been lurking in the shadows for the past several years have re-emerged with gusto over the past two weeks. Although, the late summer rally in the dollar that has seen its value increase roughly 8% against the Euro, the case for a sustainable reversal in the fortunes of the greenback is neither persuasive nor compelling.
The trend in the value of the dollar since mid summer of 2002 has been downward. The accommodative monetary policy at the Fed and benign neglect of the greenback of the Bush administration has been the primary culprits behind the debasing of the dollar. Yet, the rapid decline in the value of the US currency over the past year has been driven just as equally due to lingering problems in the financial system and what at best can be described as a sluggish economy.
The economy in the second quarter of 2008 has reached the middle apex in our "W" growth scenario, with the revisions to overall output currently poised to see growth at or above 2.5%. Yet, once one looks out over the next few quarters there is very little to support growth. Our estimate of personal consumption in the second half of the year will do well to see any positive growth whatsoever. External demand, which has been the major source of output over the first half of the year looks to moderate and the fiscal stimulus has already begun to fade.
After long hard slog in the markets over the past year, market actors deserve a healthy bout of sunny optimism and a temporary era of good feelings during the waning days of a the light summer trading season. Perhaps, that is not cause for a dismissal of fundamentals. A consumer on the ropes, the expected decline in demand from abroad, and more trouble from the financial sector, which we expect to be the overarching conditions that will define the next few quarters, are not conducive to dollar strength. We are a little uncertain how softening demand abroad for US goods and services, which will kick out the remaining pillar of support for the domestic economy, is a dollar positive event. As long as these conditions continue to provide a framework for the domestic economy the medium to long term prospects for the dollar will remain weak at best.
So, if the troubles that lie at the heart of the US economy will continue to persist why the sudden outbreak of optimism on the dollar?
First, the moderation of aggregate demand in the Euro zone and in Japan has buoyed the spirits of market actors that the cost of commodities in general and oil in particular have seen their peak. The sharp increase in the price of oil was accompanied by a precipitous decline in the value of the dollar. Hence, once cracks in the growth prospects abroad begin to appear, traders took this as a cure to begin dumping Euros, Yen and British pounds for US dollars.
Second, after hiding in witness protection programs for the better part of the past decade, the perma-dollar bulls have reappeared on the scene with a vengeance. The transitory shift in the global monetary bias from that of inflation to that organized around growth among the major central banks have produced claims that the six-year trend down in the value of the dollar has ended and that a new day has dawned in the forex markets: one of dollar supremacy.
A systematic examination of both the macroeconomic environment and the rolling crises in the domestic system of finance tells a very different tale. Regardless of transitory changes in the expectations of market players, the global tectonic plates have shifted. Even with the current account deficit having fallen to -5.30%, the international economy still faces a global imbalance between US savings and international consumption that will take years to correct. Given that the it will be at best a decade or more until demand from emerging markets can facilitate a rebalancing of the global economy, the primary mechanism through which that phenomenon will occur will be through a decline in the value of the dollar.
Claims that the prices of commodities have reached their peak are questionable at best. There has been a profound structural shift in the composition of demand for basic commodities and energy. The price of oil has seen a temporary correction, but the economic conditions are still in place on an international basis, even with a modest reduction in the rate of Chinese growth to just below 10.0% to maintain commodity prices at elevated or higher levels for some time to come. The shift in overall demand for goods and services by emerging market countries is a permanent feature of the international economy that does not support claims a decisive long-term change in the direction of the dollar.
A simple look at the breakout of sunshine in the markets bears witness to what is occurring. The negative narrative in the international economy is located in Japan and the EU. Neither have been exactly, the star players in the global economy over the past decade. The real story in the global economy has been China, India, Brazil and the remainder of the emerging world that last I looked was responsible for over 47.55% of global growth according to the IMF. China and India alone, based on the revised purchasing power parity data was responsible for a combined 15.50% of total growth in 2007. These countries will not see economic contraction, but rather slightly modest rates of growth. This does not support the type of a fall in the cost of commodities that too many market analysts and financial media commentators have been foreshadowing recently.
The problems in domestic system of finance are on the road to reaching their dénouement. But, they are far from over. There are at least two major banks still limping along and subject to further financial pressure due to the rate of defaults in the mortgage market, not to mention the 300 smaller banks that our friends at the Royal Bank of Canada believe will be declared insolvent over the coming year.
In the span of just under three weeks Fannie Mae and Freddie Mac saw more than 60% of their market capitalization evaporate. It was only the joint intervention of the Fed and the Treasury that prevented a meltdown. At this juncture our discussion with market players does not support the idea that the market is ready or willing to support the twin GSE's should they seek capital through the floating of equities. The possibility that the market may choose to reject funding of Freddie Mac in particular may be the next big financial event and could require the Fed to design and implement other unorthodox programs to meet the liquidity needs of the twin GSE's. Whether the Fed intervenes comprehensively or the Congress essentially writes a blank check to fund its own mistakes, it would be a profoundly dollar negative event, not to mention inflationary.
In our estimation, the recent moves it the foreign exchange markets represent a transitory shift in expectations among market players of global economic output and the price of oil. The volatility in the markets over the past few weeks, however, does not alter the long-term prospects for the dollar. The fragility of the financial system and the now clear difficulties ahead for the domestic economy does not provide the environment in which the Fed will be raising rates anytime soon. In fact, chatter on Wall Street has turned to considering the possibility of rate cuts at the end of the year or early next year. At the publishing deadline of this article, the options market is pricing in a 27.7% probability of a reduction in the Federal Funds rate to 1.75% at the December 16 meeting. While, because of our deep philosophical preference for sound money, we would be less than enthusiastic about such a move, it cannot be entirely discounted. Nor are we changing our Fed call to expect that it will. But, we would not be surprised if the economic and political conditions between now and the December meeting have changed in such a material way that market expectations will have moved just as sharply in the direction of further dovish action out of the Fed and a resumption of weakness in the dollar.