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Tuesday December 28, 2004 - 01:27:15 GMT
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Bearish Forex: Dollar In 2004, Bearish In 2005

Bearish Dollar In 2004, Bearish In 2005

It is usually unwise to read much into thin year-end markets, but the new high in euro/dollar reached Monday in the Americas' session is surely symptomatic of growing consensus that the dollar downtrend has months more to play out. Record US external imbalances require record lows for the dollar...and with just 5% above the record low (euro high) hit in February, plenty more new dollar lows can be expected. This is especially so when one considers what little is being done to address low US savings and high foreign savings that drives the US current account deficit. Foreign exposure to US assets and the dollar remains high by definition and investors need to at the very least reduce purchases of more US assets and hedge currency risk for existing US holdings. Is it any wonder that foreign central banks have been among the leading sellers of dollars in November? While the Bush administration has pledged to cut the US budget deficit in half over five years, it is simultaneously proposing privatizing Social Security accounts which carry a up front $1-2trln transition cost. And the record on cutting government expenditures is nothing to write home about. Homeland security, war in Iraq and Afghanistan and expensive Medicare prescription drug subsidy are blowing the roof off the budget deficit. So getting to the promised land of deficit reduction requires growth rates running 5-6% if not more. Moreover the administration and Congress's general objection to tax hikes makes deficit reduction fanciful. So the weak dollar remains the only game in town to drive the external adjustment. Indeed anyone short dollars implicitly is saying budget deficit reduction by the Bush administration is not in the cards...quite the fast will the budget deficit grow.

So where can the dollar find relief ahead? The Fed. The Fed will need to hike a lot more to slow the dollar's decline. Higher rates will encourage savings over consumption. But the Fed is not raising rates to support the dollar (check imported inflation...not worried much about it) and has shown no inclination to speed up the pace of tightening from its current measured one. At most Fed tightening (and higher Treasury yields) will simply keep the dollar decline orderly. Moreover, if the Fed hikes too quickly it could undermine the housing market, which has been key to driving personal consumption via refinancing and the wealth effect. The Fed is eager to remove policy accommodation for fear it could fan inflation down the road. It is not interested in checking consumer demand or business investment at this point in time...overheating is not high on Fed's list of risks for 2005. At most the Fed is a reserve parachute for a falling dollar.

Another main "support mechanism" for the dollar is economic underperformance in Europe and Japan. Often relative growth rates determine the value of the dollar. If the US economy outgrows Europe's economy, it follows the dollar should strengthen. Well not always. Record deficits in the US have crowded out the relative growth prop for the dollar. And if anything a stronger US economy exacerbates the US external imbalance leading to even more dollar selling pressure. No doubt markets shift focus, even within a trending market, and weakness in Europe and or Japan could translate into a dollar bounce. But the trend of a lower dollar on the US structural imbalance should reassert itself even in moments of concern about sluggish activity abroad.

Perhaps the best hope for a decent reversal in the dollar (certainly not one I expect to see), would be a very definitive response from G7 led by the Bush administration. Essentially, the Bush administration would protest the dollar's decline of it did not welcome it. And the more European officials (Japanese officials have been largely reluctant to criticize the Bush dollar policy and practice than European officials), the more the Bush administration will resist leading an official, unified protest. No doubt the dollar is well past purchasing power parity...a trip to any New York electronics store loaded with European shoppers will tell you this instantly when a euro/dollar chart does not (so would a trip to Paris for any American). But who said parity is needed when the adjustment process is all reliant on the currency adjusting? A very large overshoot is needed to get the job started much less finished. Moreover the litmus test for US official dollar concern remains US stocks and bonds. US stocks are surely not suffering from a weak dollar. Bond yields are rising but finding a bond trader who blames the dollar is no easy task. Yes this could orderly dollar decline could become disorderly. However, there seems little in the cards to make this decline disorderly. So no banana republic scenario for the dollar is expected. And hence the level of concern European officials have over the dollar is not now nor expected to be shared by the Bush administration.

So I see a very good chance of running up to 1.45-1.50, even by the early February G7 meeting in London. And 1.60 can't be ruled out before the dollar begins to recover on a sustained basis.

David Gilmore


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