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Sunday April 27, 2008 - 20:11:45 GMT
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Dollar Reality

Before we give the resurgence of the dollar too much credit let’s perform a reality check. As of Friday’s close at 1.5605 the euro had fallen slightly more than four big figures, or 2.5% against the dollar in just four days. The record high for the euro of 1.6020 came this past Tuesday. But since February the euro has risen 9.0% against the US currency. For the past five weeks the euro has been trading between 1.5500 and 1.5900 with one dip below and two attempts at the top; 1.5605 is just 100 points from the middle of that range.

American statistics have not improved. But, except for the housing market, the hope is they may have stooped deteriorating. The April 19th weekly jobless claims were considerably less than forecast, 342,000 versus 377,000, but the four week average remains at borderline recession totals. New Home Sales fell to 526,000 in March, the lowest level since October 1991; sales are 36.6% lower than a year ago. Retail sales have been volatile but whatever the actual effect on consumer spending there is no discounting the effect of falling home prices on consumer attitudes. They are seriously depressed. The median new home sales price fell 6.8% in March, off 13.3% over the year. Similar drops are recorded for existing homes, the repository of the greatest portion of consumer net worth. The University of Michigan April Consumer Confidence at 62.6 shed almost seven points in one month. In contrast builder’s attitudes have been stable for several months, albeit at very low levels. But until the backlog of construction is cleared, and only price reductions can accomplish that, there can be no stability or recovery for prices. And it prices that matter for consumer confidence.

Durable good orders in March fell for the third month in a row. But perhaps more encouragingly for consumer spending the ex-transport sales number rose for their first time in three months, adding 1.5%. This figure excludes the sale of commercial aircraft (new orders for Boeing Corporation dropped from 125 in February to 99) and civilian aircraft whose orders rose 5.5%.

On the European side EMU business confidence figures, particularly the March Belgium Business Survey and the German Ifo have been considerably weaker that expected. Consumer confidence is also at low ebb in most of the major EMU countries.

Is the pending 25 basis point cut in the Fed Funds target rate on April 30th the end or the beginning of the end to the Fed reduction cycle?

Three factors are driving that possibility. First is the time frame. Since last September the American Central Bank has cut its base rate by 3.25% (April 30th included). Rate cuts of that magnitude in a little over eight months should have a pronounced stimulative effect within six to twelve months. The historical evidence is quite strong. Secondly the Fed knows it will have to deal with inflation sooner or later. It is far easier to prevent inflationary expectations from arising than it is to squeeze them out of a market once incorporated into contracts and financial projections. And third, though the credit crisis appears to have subsided, safety for the financial system warrants caution and caution warrants a reserve of rate cuts if needed.

All of these factors are well known. One might say this is now the conservative scenario.

If the US growth bottoms at -0.5% in quarters one and two (this is lower than the median current expectation) and then resumes, it could quickly surpass European GDP which is predicted to be at 1.2% for all of 2008. A US economy, naturally more flexible and responsive than its European counterpart and under the spur of 3.25% in rate cuts, could return to 1.5% – 2.0% growth is the latter part of this year. Clearly this is only a possibility but it cannot be ignored. It is not a possibility that supports a euro worth 1.6 US dollars. In addition, the ECB has striven diligently to remove any expectation of a rate cut in 2008 from market calculations. But even the smallest signs of a slowdown in the EMU and the speculation will seep back.

The two main drivers of exchange rates, economic performance and interest rates, may be shifting to the dollar advantage. There is as yet scant proof: it is all conjecture. But speculation and conjecture are the heart of trading. Returning US growth follows the standard economic cause and effect model—rate cuts produce expansion. It has historical precedent and traders have demonstrated they are unwilling to push the euro above 1.6000. Betting on the dollar may be highly speculative but it has become the only game in town.

Joseph Trevisani
FX Solutions
Chief Market Analyst

[email protected]

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