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Tuesday February 1, 2005 - 11:32:47 GMT
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Dollar bulls are emerging


“I am not bound to please thee with my answer.”

Shakespeare, The Merchant of Venice

FX Trading

Dollar bulls are emerging—putting some meat on the “old dollar” bones. But few seem as bullish as Morgan Stanley economist Stephen Jen:

• “The FX market has only in the last month ‘woken up’ to the fact that the Fed will be the only major central bank that will likely tighten significantly this year. As long as the Fed continues to be seen as ahead of the curve, further tightening by the Fed should be USD-supportive, in my view.”

• “Second, the US, the Treasury reasserted itself on the issue of the dollar policy. For most of 2004, the US Treasury was seen as rather passive, but it has redefined its strong dollar policy. For the first time, the strong dollar policy is now linked to prudent fiscal and monetary policies, rather than just a vague statement about an asset price.”

• “By year-end, it is possible that the fed funds rate will be 3.75-4.00%. Compared to the BOJ’s 0.0%, this is a daunting hurdle to overcome, as capital flows out of Japan in search for yield. In a way, therefore, the call for USD/JPY to trade lower is a race against the Fed.”

• We have just updated our quarterly fair value calculations. The upshot is that, compared to current economic fundamentals, the major USD index is still undervalued, and, in bilateral terms, is deeply undervalued against the EUR, GBP, AUD, and NZD. EUR/JPY is still the most mis-priced G10 cross rate. USD/Asia is by and large fairly valued. Any prospective pressures to push USD/Asia lower will sow the seed for future volatility.

And some more bullish talk on the wires:

• Canadian Finance Minister Ralph Goodale told CBC Radio that the recent rapid rise of the Canadian dollar had created a "major uncertainty" ahead of the budget. (Reuters)

• Swiss Economics Minister Deiss said last Friday: “The US dollar “continues to be at a level that poses a problem to Swiss companies exporting into dollar countries or countries that are using the dollar.”

Others are beginning to believe the dollar looks cheap. Our themes for a multi-month rally haven’t changed. Here they are, as presented to our clients over the weekend:

1) Extreme negative dollar sentiment – Granted, much of this negative view has been shaken out of the market, thanks to a powerful move in the buck in ’05. But, as I have said before, I think this represents the first stage conversion flow. We know, based on the headlines, there are plenty of big players (a la bank analysts, Buffett, Gates, and Soros) who still hate the dollar. They have yet to capitulate to the dollar trend.

2) Relative US economic growth – Friday’s release of advanced GDP for the fourth quarter showed the US growing 3.1%, and 4.4% for the year. This is not runaway growth. And there are plenty of concerns on the horizon i.e. consumer demand, jobs, housing etc. But, relative to the major competitors, the US looks good. And with the background potential of US multinational repatriation, sparking more direct investment, it should be a decent prop for the dollar.

3) Interest rate differential – Though you won’t know it watching long bond prices, the Fed has given no indication it will pause in its campaign to “normalize” interest rates. Until we know otherwise, this will continue to be a powerful intermediate- to long-term prop for the buck. Granted, much of this realization is in the market place. But, never underestimate the process of surprise as it plays out in the market—especially on the interest rate front. I think we are witnessing a bit of the inflation premium being squeezed out of the long end of the yield curve—adding to the attraction of long bonds (see Currency Currents 19 Jan ’05 for Hoisington economic forecast). I don’t believe it has any impact on the Fed’s plans.

4) A falling dollar will not solve the US deficit problem – This is the new theme emerging, as I have laid out in Currency Currents lately. I think this could be a very powerful theme because it runs directly counter to the most public dollar bears and represents a paradigm shift of sorts.

We emphasize “multi-month” when we express those themes. The dollar has made a nice run since the beginning of the year. It looks a bit “overbought.” So a correction would not be surprise. Here’s a look at the dollar index chart daily chart:

US Dollar Index daily

The US dollar index can at times be deceiving. The biggest component of the US dollar index is the euro. And the currencies are NOT moving in tandem against the buck. For example, the euro, Swiss-$, and Cad-$ look a bit oversold, while the Aussie, British pound, and yen look a bit overbought.

So sure, we could see the usual backing and filling correction in the buck. Or we could see more and more players warming to the themes we have laid out. If so, the dollar index will look a lot more “overbought” than it does now. Either way, the bullish story for the dollar is still in play.

Jack Crooks.


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