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Monday January 10, 2005 - 11:24:21 GMT
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The dollar move has legs


“Rare events are always unexpected, otherwise they would not occur.”

Nassim Taleb

FX Trading

The dollar is giving some ground this morning after a week which almost demolished many New Year’s currency forecasts. This morning, the Financial Times summarizes the “surprising” dollar move relative to the seemingly one-way bearishness among a cadre of prominent bank FX analysts. Said analysts are still “keeping hope alive” by not yet capitulating to the dollar move. But, as the market’s conversion from extreme dollar bearishness, to dollar neutral, then to dollar bullishness plays out, the analyst capitulation will provide the fuel to sustain a multi-month dollar move.

The conversion flow is in its early stage. I have hung my forecasting hat on two rationales: 1) Relative economic growth, and 2) a rising positive US yield differential. Two rationales laid out as dollar drivers in this publication on December 22nd 2004. I believed then, and I believe now, the forecasts calling for Euro-$ 1.40 and a British pound at $2.00 were, and still are, based on a very stale rationale: the looming US “twin deficits.” We need to work from the belief that if everyone knows the reasons, there is no surprise. And ultimately it is surprise that moves people and people who move prices.

The conversion-flow to at least dollar neutral, and even dollar bullishness among a quiet minority of analysts, is based on their surprise over the seeming aggressiveness of the Fed to remove monetary stimulus in the form of hiking Fed Funds. That is still the main dollar driver in our book. The new rationale is emerging quickly. We turn to a consistent dollar bear, Morgan Stanley economist Stephen Roach for definition:

“Rarely does the US central bank cast aside the rhetorical shackles of Fedspeak and express its concerns with such candor and fervor. Two earlier instances in the recent past stand out as intriguing precedents -- late 1993 and early 2000. In the second half of 1993, the Fed warned repeatedly of excess speculation in the bond market and the coming normalization of monetary policy. Market participants all but ignored the warnings until the Fed finally delivered in the form of a 300 bp rate hike over a 12-month time-frame beginning in February 1994. The result was the worst year of performance in modern bond market history. A similar, albeit belated, warning was sounded in early 2000, when the stock market was still bubbling to excess.”

Mr. Roach believes the Fed is desperately behind the curve and will hike rates further and faster than the market now believes. Bingo!

Mr. Roach is talking our story. And one of his colleagues, Mr. Joachim Fels, is adding to the cake with his view on differing central bank policy:

“[T]he monetary policy paths in the US, in the euro area and in the UK are likely to diverge more this year than they did over the past few years. Just look at the rhetoric in the three banks’ December policy statements and minutes. According to the FOMC minutes, some members (though a minority) have expressed worries about upside risks to inflation and about asset price inflation. At the same time, the ECB moved from “strong” vigilance regarding inflation risks in November to “continued” vigilance in December and even dropped the phrase expressing concerns about asset price inflation. Meanwhile the December MPC [UK Monetary Policy Committee] minutes showed that some members were starting to worry about downside risks to the (benign) inflation outlook, which suggests to me that the odds of a rate cut this year have risen. The reasons for this emerging divergence are not difficult to find: currency appreciation reduces inflationary pressures in the euro area, and the developing downturn in the UK housing market could weigh down on UK consumer spending and inflation. With the Fed likely to raise rates at the next several meetings and inflation creeping higher, the ECB likely on hold at least until the middle of the year, and the Bank of England possibly starting to cut rates this year, my guess is that UK gilts will outperform both Bunds and US Treasuries.”

This is exactly why we believe we’ll see a sharp and rising positive US dollar yield differential. It will surprise! It should be the final nail in the coffin for bank analysts clinging stubbornly to their year-end forecast—the catalyst that leads from bullish conversion flow to outright capitulation to the dollar trend. That is why I believe this dollar move has legs.

Jack Crooks


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