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Tuesday November 30, 2004 - 21:54:50 GMT
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Forex: Bonds Catch Structural Flu From FX...Perhaps

Bonds Catch Structural Flu From FX...Perhaps

One of the glaring inconsistencies in the weak dollar trade has been the question of funding the US current account deficit. While every currency trader from Auckland to New York has confidently sold dollars on the notion the US can't keep funding the growing external imbalance indefinitely implying a weaker dollar, finding a bond trader to say the same thing has been difficult if not impossible, well until Greenspan said so November19. And then there was Monday. Like any asset price, it often takes a big price move to generate critical mass in a story or theme explaining why prices changed. Looking at Forex: the long end of the US yield curve Monday (mild carnage), one could imagine James Carville saying, "It's structural stupid."

Okay one day does not make a structural trade in bonds. But it is worth watching and if it is real then it implies sharply higher US rates at the very least and a growing risk of an ever weaker dollar leading to an ever weaker bond market leading to an ever weaker dollar...a vicious circle. Though it could be an orderly vicious circle. I simply do not buy the dollar crisis risk (as in is low) and think few investors including foreign central banks are giving up on the US Treasury market much less the dollar. They are doing what any rational investor would do...diversifying. Liquidating is an extreme act and there is nothing in US fundamentals to force central bankers or private sector investors to dump trillions in US Treasuries. This adjustment process is all about allocating less capital to the US Treasury market and not running for the exits.

No matter how much complaining is heard from Europe and Asia over the weak dollar and the markets are doing what they are supposed to do in the face of a record US current account deficit problem and in light of a second hard currency the euro. The market is adjusting and doing so in an orderly fashion. No wonder the US Treasury is not hitting the panic button on the dollar or jumping into action behind the coercion of disgruntled European monetary authorities. Remember Snow said at the Berlin G20 meeting that currency accords have a checkered past (costs outweigh the benefits I add). And Taylor said a few weeks ago that the decline in the dollar was orderly. One would think the US Treasury has a pretty good idea what is happening with end-investor demand for US government securities and is quite confident that the world has not lost confidence in US assets and the US currency.

As far as the ECB and Eurogroup are concerned, when they launched it in January 1999 it traded around 1.16 and to a person officials were claiming it had a future as a reserve currency. Two things...the euro has indeed become a reserve currency and it is about 15% higher than its launch date. Does that sound like an overshoot? For a reserve currency? And the euro traded as high as 1.29 in January of this year and using this yardstick the euro is only 3% above the January high.

Moreover the US Treasury is surely thinking about the changes that a weaker dollar may put into motion in Europe. Necessity is the mother of invention. Structural reform in Europe is critical to Europe's long-run competitiveness and if a weaker dollar and higher euro turns government pledges into government action than the market (not the Bush administration) is working. That said it is no mystery that the main currency zone where the US Treasury would like to see the dollar decline is in Asia, beginning with the Chinese yuan. Europe is in agreement with the US on the need for Asian currency appreciation versus the dollar and by implication the euro. Call it burden sharing. But in absence of a yuan revaluation, the US Treasury is not any closer to currency intervention at 1.35 in euro/dollar than at 1.29 in Q1. Simply it does not have to worry about a collapse in the US bond market with one caveat...sound US fiscal policy is a precondition to maintaining investor confidence in US government debt. The recent record is not encouraging, but far from fatal. No doubt the sting of Social Security reform was felt on Monday (drove rumors of a return of the 30-year bond, though this may have been another case of "news chasing price"). Financing tax cuts has not been addressed by either the White House or Congress in three years. Most rational financial enthusiasts do not believe tax cuts finance side economics does not hold up under empirical evidence plain and simple. Sure unfunded tax cuts are generally less costly than unfunded spending increases. But there ain't no free lunch. Yet Washington is full of believers in the free lunch myth. Between the White House and Congress, much needs to be done to assure owners of US government debt that spending cuts and even tax hikes (call it closing loopholes as Reagan did) must accompany act of Congress to make existing tax cuts go should be embraced. It is interesting to note that Snow is no supply sider (before coming to Treasury), nor was O'Neill. The next US Treasury Secretary must come from the hardened pay-go side of the fiscal spectrum or owners of US debt will have a confidence problem.

Don't get me wrong, foreign central banks are accumulating fewer US Treasuries...MoF said so last week and China said so before it said it did not say so. Regardless this is natural and part of the adjustment process. Greenspan knows this and why he said the deficit is unsustainable and implies a weaker dollar and or higher market rates. Denying this adjustment would elevate the risk of a crisis or dollar collapse and spike in US Treasury yields. This is why Greenspan's remarks in Frankfurt last week were the bond market and FX equivalent of irrational exuberance for stocks, though this time I doubt Greenspan forgets about the need for adjustment.

Where things get dicey for central bankers and eventually even the US Treasury is if China delays a reval (moreover drags out the entire process to full convertibility) and the dollar continues its decent mainly versus the euro. This could turn into a vicious circle. And one could imagine European investors liquidating US assets. Surely not even a strong US cyclical story and a weak Euro Zone cyclical story will be enough to keep the dollar decline orderly. Never say never, but I am sticking with the orderly theme for the dollar and yield curve.

David Gilmore


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