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Monday November 8, 2004 - 15:24:33 GMT
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Forex: Trichet Protests Dollar Slide, China Defends Peg, US Jobs Hum

Trichet Protests Dollar Slide, China Defends Peg, US Jobs Hum

You would have to search very hard to find anyone more bearish on the outlook for the dollar than myself. But it would be foolhardy to believe that the structural theme of towering twin deficits can alone drive the dollar lower, indefinitely. The stars need to be better aligned to keep this trend going and right now the night time sky is only partially visible.

Don't get me wrong. Running a near 6% current account deficit as a share of GDP is unsustainable. But structural themes like the current account deficit and its subset the budget deficit are rarely adequate cause for day in and day out liquidation short of a funding crisis. And the US is not an emerging market economy on the verge of default, credit downgrades and a run on the currency. Indeed, even maintaining an orderly dollar decline will demand a greater alignment of causal factors than simply wider US twin deficits and a de facto weak dollar policy.

What is missing sort of? An unambiguous cyclical story is essential to any sustained period of dollar selling in absence of a funding crisis. A US slow patch and a Euro Zone updraft would be ideal. But Friday's US jobs report for October suggested that the slow patch vanished this fall (not in the spring as Greenspan asserted in Congressional testimony). Moreover, the German economy is wounded. Domestic activity is flat to down and short of strong exports, Germany would be flirting with recession. Not all the Euro Zone shares this problem...French domestic demand is firming and real estate is booming. But as Germany goes so goes the Euro Zone. And it is with this in mind that Trichet today resurrected the brutality comment that first appeared in January. Trichet said after today's BIS meeting that the move up in euro/dollar is tending toward brutal and unwelcome. While Trichet may have implanted a smidgen of two-way risk into the psychology of traders it is unlikely that he turned the tide. Indeed when Trichet protested the dollar's decline earlier this year the US cyclical story was on the verge of giving the FX market lots to chew on...spurt of inflation in the spring (before oil really took off), start of the Fed tightening cycle and calls for ECB rate cuts. Currently the Fed is nearly complete with ending ultra-policy accommodation (restoring positive real Fed funds rate or 2.00% nominal rate) and ready to adjust rates solely on the data with an emphasis on flexibility. And low inflation should keep the Fed more inclined to get GDP up to a rate that will grow jobs. The October jobs report suggests this pace may already have been reached. But more likely the Fed is lacking a preponderance of evidence to conclude that NAIRU has been reached. My point on the Fed is that future rate hikes from Wednesday's move to a 2.00% Fed funds rate will likely err on the side of accommodation. Furthermore, the Fed is still quite focused on first-round effects from the rise in oil...mainly headwind for the economy through tax on consumption and corporate profits. Last Thursday Trichet was unequivocal on the policy bias...balance of risks are tilted toward inflation. While an ECB rate hike is not in the cards now, and a rising euro buys some time before the ECB hikes, it is reasonable to conclude that the cyclical story is on balance bearish the dollar and bullish the euro, though lacking in thrust.

Enter China. China's much awaited yuan revaluation seems to have a Chinese sense of urgency and not a Western sense of urgency. A wider yuan band (versus the dollar or a new basket of currencies) would be an entree to selling dollars more broadly. Unfortunately, the Chinese authorities are not really keen on making a change now, or ahead. Sure 2005 seems reasonable for a wider yuan band, but this could be delayed until year-end.
China's central banker Guo said at BIS today that there is no timetable for a revaluation and that the dollar decline may prove short-term. Surely, the latter remark was a reflection of the heat China is facing at the G10 level, and the desire to see China and Asian currency appreciation. As long as China stalls on a revaluation, the more markets will perceive China as a dollar and US Treasury accumulator, reducing concerns over financing the US current account deficit.

Intervention risk is low despite steady rhetoric from Japan and now Trichet's first verbal protest. Inflation is a growing concern for the ECB which should cast the euro rally in a very different light. Currency appreciation is a form of tightening monetary conditions. Okay if Trichet had his druthers it would prefer to remove policy accommodation through interest rate hikes rather than a higher euro. But the euro at 1.30 is not wholly unwelcome. Furthermore the ECB has made it clear that it does not have much faith in currency intervention and when the tool is deployed, multilateral intervention is preferred over unilateral intervention. This begs the question of what will it take to get the Bush administration to intervene using US resources? A disorderly dollar decline of that sends stocks and or bonds into a severe decline. So put intervention in euro/dollar to bed for now. Japan intervention is threatening to return from a lengthy vacation (last intervened March 16 and before that Japan was engaged in an orgy of dollar buying lasting well over a year). But even Japan is less inclined to intervene to put a floor under dollar/yen as was the case until March. The Japanese economy is in better shape, though surely not out of the woods yet. So the case for intervention is less than it was in the spring. That said Japan should soon begin intervening again...though this time around the exercise will be aimed at smoothing the move down in dollar/yen, not preventing one. Conveniently, Japan will resume accumulating dollars and US Treasuries albeit at a pace a shadow of what was seen through March. Where does this start? Probably under 105, and look for discreet intervention as well.

How does the current account story hold up across markets? Not great. US Treasuries are not weaker on the notion that foreign investors are selling. Rather Asian monetary authorities = were large buyers last week when the dollar was selling off. If the current account story is truly driving a major realignment in portfolios, by definition look for a steady rise in US yields. And further down the road a current account funding shortfall would also pressure US stocks lower and right now this market is bid.

My point today is simple...the dollar bear trade is still favored, but it is simply not a one-way street. From the viewpoint of flows, real money is participating and this should reduce the speculative position flushes that we saw through early October. Meanwhile be patient with the short dollar trade and wait for a more optimal alignment of causal factors beyond simply Bush as a budget buster and US Treasury as a weak dollar steward. The real power in the downtrend ahead necessitates weak US fundamentals (this will help reduce the c/a deficit, but like strong jobs data suggesting wider deficit, doubt this plays into a bullish dollar outcome). Between the Fed pausing on rates once emergency accommodation is removed, record household debt and headwind from oil, I am confident the cyclical story will merge with the structural story ahead to provide the most powerful dollar decline in two decades.

David Gilmore


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