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Thursday May 13, 2004 - 22:01:30 GMT
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Cyclical Story Dominates Structural Story On Dollar

Cyclical Story Dominates Structural Story On Dollar

Wednesday's record US trade deficit for March did impact the dollar as the market switched focus away from the cyclical story that had been supporting the dollar (higher Fed funds rate) since early April to the structural story (funding the US current account imbalance) that drove the dollar for some if not much of the two-year decline through February. Well it switched the focus briefly. The focus today, if prices tell us anything, switched back to the cyclical story or the impending Fed rate hike (US economy growing at a faster relative rate than the rest of the world).

It is reasonable to expect the cyclical story to remain the dominant theme for the FX market for the near-term anyway. The Fed has yet to start raising rates. US GDP ran at its highest on an SAAR basis for the last three quarters ending Q1 than it has at any other comparable time in two decades. And there is no indication yet that Q2 will be considerably slower. Furthermore the pace of growth remains largely independent of global demand as domestic demand is buoyant.

On the contrary, growth in Europe is considerably less impressive barely growing at all in 2003 and only in Q1 starting to show some acceleration. Italy, German and France GDP in Q1 all surprised to the upside and Euro Zone Q1 GDP out Friday is expected to show 0.5% q/q gain (close to 3% SAAR). But Euro Zone growth is largely export dependent as domestic activity remains sluggish at best in Germany, Italy and France and hence vulnerable to currency swings and foreign growth rates. While the euro is well off the highs of January and February, it is still strong. Oil prices are rising and staying high and are a brake on demand in the short-run...inflationary over time. This is surely not the environment for higher ECB rates. Okay a rate cut is no longer in the cards as we argued a few weeks back, but this central bank will be lucky if it can follow a third Fed rate hike with its first rate hike before all is said and done. So with cyclical story dominant the euro should fall and the dollar rise...it is and it will continue (1.10-1.12 target band) before the structural story has a chance of returning to the forefront.

And Japan is working through a false sense of recovery. Markets arguably got ahead of the economy through March. But recent data on capex and household spending suggest the excitement over domestic demand was premature. A few months does not a trend make. Indeed the price action in the yen and Nikkei say something about the recovery more along the lines of one step forward two steps back. Investors are fleeing Japan assets (stocks) and selling the currency. Japanese institutional investors are also buying foreign securities (have been since April), even with higher nominal rates in JGB's. Upcoming Q1 GDP for Japan is expected to be 3.5% SAAR, which is not shabby), but it will largely reflect net exports. The more diversified Japanese economy has yet to arrive. Moreover, with China stepping on the brakes, Japanese exports into Asia are at risk. And while the cyclical story dominates it is reasonable to look for dollar/yen to rise to the 118-120 area.

When does the structural story come back to haunt the dollar with staying power? Well Fed tightening alone is rarely sufficient to drive long-term dollar rally. Indeed the market may get to pricing in Fed rate cuts for the next year. It has priced in as much as 135 basis points this year based on the lows in the eurodollar contract. One can expect a dollar rally driven by cyclical assumptions to run out of gas somewhere around the second rate hike in the cycle. Remember the dollar weakened through much of the 1994 tightening cycle.

And foreign investors have to become sated with US assets before the current account funding story is manifested in dollar weakness. It may well take a significant shock to financial markets to prompt this decision by foreign investors like a bursting of what I think is a credit market bubble in the US. Perhaps it could ollow another terrorist attack on the US and a Bush-administration response and a surge in global risk aversion. Or it could simply unfold over time with little fanfare until price action convinces the market that foreign investors are not putting much new capital to work in the US. While not expected it could come in the form of a spurt in US inflation.

But the structural story will come back one way or another...it is basic economics. The only way to avoid it is by the US increasing its savings rate. I am confident the rest of the world will not dig the US out of its dependence on global savings by becoming low saving, high consuming economies. And there is no political party eager to address low US private consumption with something like a VAT system replacing much of income tax that would encourage savings over consumption. Government could help the preferred adjustment path as well with something where there is political support across party lines...budget deficit reduction. Budget surpluses are a starting point for avoiding the harsh adjustment that a dollar devaluation would bring if the status quo persists.

David Gilmore
FXA

 

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