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Three Strands of the Dollqar

Market Directions September 07, 2008 Forward to a friend

First in First Out

There was little good news for the American economy in the August Non Farm Payroll report. The unemployment rate jumped 0.4% to 6.1% and 142,000 jobs slid into non existence. This brought the total United States job depletion to over 600,000 since January, eight straight months of job losses. The weekly jobless claims accounting was equally dismal, 15,000 workers joined the rolls and the weekly total rose to 444,000, recessionary territory. The monthly moving average is now 438,000 over 100,000 higher than it was six moths ago. 
The dollar however, belonged to a different universe. On the week it gained 3.2% against the euro, 2.8% against the pound sterling, 5.4% against the Australian dollar, and 4.7% versus the New Zealand Dollar, only against the Canadian dollar was it unchanged. At its euro close of 1.4235 it was within 40 points of the bottom and at a level not seen since last October when the dollar was in the first throes of the credit market meltdown. Since the low on July 15 at 1.6040 the dollar has now appreciated 11.3% against the united currency. It is only against the yen the dollar has been declining. And that is due solely to the pressure from the tremendous deleveraging fall in the yen crosses. Euro/yen itself is off 10% since its peak in July and it fell 4.3% on the week. When the yen crosses fall the US dollar is often sold against the yen as traders cover their positions in the cross components.
There are three strands in the dollar resurgence.   The first is the puncturing of the euro bubble. Euro strength had been fostered by the unrealistic idea that the rest of the world, especially Europe could avoid a recession even if the US entered one. A common trait in bubble markets is that as the market approaches its end outlandish theories are advanced in order to support the exaggerated levels. Decoupling, the floating of Europe and Asia out of the main stream of the world economy, was the outlandish theory de jour for the euro bubble. The common theme to these theories is that this time, contrary to history, logic and expectation, it will be different, this market will not crash. Recall the dot com boom when companies with no business model, no revenue and no employees were touted to extraordinary price levels on pure hope and greed. Or when the stock market was confidently predicted to go to 30,000 just before the Dow collapsed.   Bubbles do not recover. Once the illusion is punctured there is no bringing back the speculative frenzy and that is surely one of the reasons the euro has now fallen for straight six weeks.
The yen crosses have also added to the pressure on the euro. These crosses are vulnerable to signs of economic disturbance. Speculative investments are unpopular in times of economic uncertainty and the yen crosses have been the prime speculative investment in the currency markets for several years. The is a great deal more deleveraging and speculative flight that may still occur in the yen crosses as traders try to gauge the depth of the world economic slowdown.  
The second strand in the dollar rise is comparative. The US economy is not healthy but the rest of the world is either sickening as in Europe and Japan, or about to experience  a substantial curtailment of growth, witness China, India and the emerging and developing worlds.  
Although the American housing, auto and financial sectors are in poor health or recession, other economic sectors are strong or stable. US exports are booming and perhaps keeping a general recession at bay. The economy expanded at 3.3% in the second quarter and whatever formula one uses to determine a recession that rate of expansion can not possibly fit. Other indicators are either rising moderately, like factory orders up now for five straight months, and durable goods, up for two months after five negative or flat months, or showing signs of recovery like the ISM Manufacturing and Service surveys. Even the long troubled housing market seems to have stabilized, albeit at very depressed levels, at least in the statistics for new and existing home sales. 
There are also incalculable factors for the dollar rise playing behind the statistics, factors that have not yet shown their effect in the statistics. Chief among these is the 325 basis points of reductions in the Fed Funds rate. Though the timing of an economic recovery has proved elusive it is still reasonable to assume that one will come. Historically Fed rate cuts promote economic growth. There are many credible reasons for the delay in economic response to the Fed cuts. Primary culpability must belong to the banking and credit crisis which is preventing the spread of easy money throughout the economy. But, as with the euro bubble, when analysis strays from the historical and logical models the burden of proof is on the exception not the rule. With the current set of economic factors the US should find returning growth before Europe and Asia.
Another bubble, and not unrelated to the euro, has been the extraordinary rise and fall in crude oil prices. Demand for oil and energy products are raising as vast areas of the world industrializes yet supply is stagnant. But it was not an increase in demand that prompted the doubling in crude prices in a year. As with the euro there has been little retracement in the oil price.  And as with the euro, a bubble by any other name is still a market of no return.  
One final incalculable effect on the American economy is the consumer effect of the drop in energy costs. Oil is the basic industrial commodity and it acts as a tax on the economy and especially consumer spending. Lower oil prices mitigate the effect of inflation on consumer expenditures and consumer sentiment. Less inflation means more discretionary income for consumers, more spending, and an expanding GDP. That at least is the positive scenario from the drop in oil prices: returning domestic growth fueling GDP and replacing whatever losses in exports are engendered by a stronger dollar.  This effect has not yet taken place. Real Personal Consumption Expenditures (PCE) was only 0.7% higher in July over the prior year. But this past year is exactly the time when the skyrocketing energy and gasoline prices shocked consumers. As oil and gas prices come off consumer expenditures should recover.
As we said earlier, the US economy is fragile. It is also an election year and the potential for a much more severe downturn is very real. But on current analysis the immediate future of the US economy appears more positive than the economies of its major currency trading partners.
Lastly we have a concept not much heard of lately and definitely not in relation to the US dollar -- flight to quality or flight to safety.   In times of economic worry and dislocation the US dollar and the US economy have always been the favored destinations for the world’s liquid investors. They remain so. As the dollar collapsed against the euro in the winter and spring investment capital flowed into the United States. These investors have received a nice bonus from the dollar’s recent appreciation. This appreciation will encourage more capital flows into the United States. These inbound investments support the dollar as it is bought and foreign currencies are sold to fund the purchase transactions. 
It is important to remember that the dollar has been falling since 2002. It is too early to say that this recovery is the beginning of a long-term reversal for the US currency. But the speed and force of the change in the dollar’s fortunes make this move a good candidate for the beginning of a substantive alteration in the market’s view of the US dollar.   

Joseph Trevisani
FX Solutions, LLC
Chief Market Analyst

[email protected]

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