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Wednesday July 23, 2008 - 20:04:18 GMT
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Forex Blog - Fed Dollar and the 3 P's

Well the dollar has rallied substantially in the last three days and particularly since Tuesday when Petroleum, Plosser and Paulson all seemed to play a part in the reversal in the dollar, or so we are told.

But since when did Plosser set Fed policy? Or Paulson impact the level of the dollar with a mantra chant? Petroleum works two ways with the dollar – elevated oil may play a role in a weaker dollar as investors hedge against a weak dollar by buying commodities. But high oil is also the key driver in inflation and the leading edge of what could allow the likes of Plosser to usher in a rate hike…which would be dollar supportive. So overstating linkages and causality between commodities and the dollar is common and may not hold up. Indeed lower oil prices will in time reflect lower demand and economic weakness which will not be helpful for the dollar.

What is clearly going on is an unwind of the end-of-the-world-as-we-know-it trade and this is driven by pain from prices and oil clearly led this process. What is the EOTWAWKI trade? Long energy and energy stocks, short financials, long commodities and short the dollar, and long Treasuries and short mortgages. Violent moves as they unfold often get attributed to things like Paulson and Plosser when at any other time their remarks would be ignored.

And the oil and Treasury story also is noteworthy – this one seems to have supportive features in a rising market (elevated headwind for consumption and corporate profits) and a falling market (lower year-over-year and month-over-month energy prices will bring headline inflation down in a hurry and could remove need for the Fed to hike as soon as financial markets stabilize.

As far as Plosser (Guha and Liesman) goes, we should all now assume that the Fed is going to hike sooner than later assuming upside risks to inflation rise more or financial system stabilizes. It just seems to be a ploy to talk the talk and not walk the walk. The Fed had a window of opportunity to hike at the end of June and chose not to partly because it had cut at the prior meeting in April and did not want to risk being seen as admitting the April cut was a mistake, I believe. But that window looks indefinitely closed.

Consumers are strapped – paying more for food and a lot more for energy. Disposable income is down sharply. Real wages are slipping. Unemployment is rising. Sentiment is weak and falling. Home ATM machines are shut. Credit card delinquencies are soaring. Credit card interest rates are soaring to reflect higher default risks. Home prices are falling still. Stock prices are down for the year from January and down y/y. Stick a fork in it. This consumer is not going to e resurrected by $100 a barrel oil. When oil really starts to unravel it will be because the economy is unraveling. Is this the world of reduced downside risks to growth and severe downturn in particular? Stick a fork in it. Plosser and other Fed hawks are delusional if they think conditions are nigh for tightening.

Like banks finding themselves over leveraged with falling asset prices and in need of balance sheet overhaul, households are in a similar position – they are highly leveraged (HELOCs, credit cards, student loans, mortgages) and need to overhaul balance sheets. But try calling a Sovereign Wealth Fund for a bridge loan to pay down 30% credit card loans. Or issue IOU’s to investors to finance your kid’s college education…invite the neighbors over…Johnny is smart and is going to a good school.

Firms, we are often told, are in fine shape, long cash and selling much more abroad. But wait just a minute. GM had a pile of cash and solid overseas businesses and it we are told is in danger of filing for bankruptcy, has the market cap of Mattel that makes toys including miniature cars. Even the bombproof Apple, Google and GE stocks have been under pressure in this bear market (last 3 days’ rally notwithstanding).

Yes I am still bearish – maybe not looking for a tall building to leap fro or a cave to move into. But this financial crisis of the last 12 months is merging with a consumer-led economic crisis and will make for a very hard landing…sooner than later. The idea that the Fed is debating when to hike is fanciful. ECB did it and is looking increasingly like it is ahead of the curve…of the next business cycle upturn that could be two or more years away.

Throughout this crisis we have seen investors and traders run across the deck of the ship and this week’s sprint won’t be the last. There is no bottom in sight when the US consumer is teetering on the verge of a major retrenchment in patterns of savings, firm profits increasingly challenged and the banking system on life support from central banks and SWFs.

Perhaps the scariest thought of the crisis is that monetary policy is not able to respond to stagflation effectively and any future countercyclical policy steps and financial market stabilization plans are going to have to come from the government. With a lame duck White House (not sure which is the operative word), that leave Congress as the primary saviors of the US economy and financial system. As long as they can borrow and spend without recourse, well then maybe we live to spend another day. But like banks and households before them, it is only a matter if time before the US government is forced to address a major overhaul of its balance sheet. Pray that this one is latter than sooner.

David Gilmore


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