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Wednesday February 23, 2005 - 21:16:00 GMT
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Dollar Searches For Balance

Dollar Searches For Balance

Is it any wonder that the dollar is being pulled around like a rag doll these days when you consider the very ($) bullish cyclical story and the very ($) bearish structural story? Moreover, combine this with the financial market's propensity for acute attention deficit disorder and if anything we might ask why the dollar is not more volatile?

The delayed reaction to the "news" Monday from South Korea's central bank was classic. By the time the dollar really hit the skids in Asia trading early Tuesday, not only did every floor broker of the NYSE claim that Bank of Korea dollar and bond sales was curtains for stocks, but every talking head on financial TV was an expert on Bank of Korea reserve management. Few bothered to check the bond market where there was hardly a budge in price/yield. After all would not the threat of the liquidation of some $200bln in mainly US Treasuries cause the bond market to weaken even slightly? Cooler heads prevailed in the Treasury market. The sad thing is that markets and much of the financial press are not very interested in truths, just sound bites...however plausible, however accurate. My point is what market participant much less news organization can say simply that they do not know why the dollar fell so sharply on Tuesday? None, that's how many. I am not immune to theorizing about why the dollar fell and think this is appropriate if disclosed as theory. But enough already of the lowest common denominator masquerading as news. This is not helpful. And for a fairly sophisticated audience it is insulting.

So if it is not the Korean reserve management story that is driving the dollar all over the block what is? My theory, only, is the give and take of the structural and cyclical themes/forces. The market exhausted the structural theme in December running euro/dollar to 1.3660. And the market exhausted the cyclical story for the dollar in February running euro/dollar to 1.2730. From a static point of view, 50% of this move is roughly 1.3150. This represents some near-term balance all else being equal. Well all else is rarely equal and certainly when it is it is not equal for long. This is where the analysis starts. How will this give and take of structural and cyclical themes play out ahead?

Near-term, we probably are due for a pause in dollar selling (surely I have the benefit of today's dollar bounce in mind), but this is no entre for dollar buying. The February payrolls (March04...due for a gangbuster gain) should revive the cyclical theme, though briefly, and see the dollar rally back to 1.30. On the other hand the stronger the US economy is and the weaker Europe and Japan economies are, the wider the US trade gap and the greater the need for foreign savings to fund this gap. My point is that even bullish cyclicals are down-the-road bearish structurals...adding to the unsustainable, ever widening external imbalance. And only much higher US rates whether in the form of higher bond yields (market rates) or Fed funds can keep the steady inflow of foreign savings ahead and ultimately lift US savings (slow domestic consumption).

Furthermore, while I am rarely in the company of the Fed/FOMC, I could not help but notice in today's FOMC minutes that members thought the US trade gap would remain large and saw few indications that overseas demand or the decline in the dollar to date was having any measurable impact on the external deficit. Short of deliberately slowing the juggernaut of US consumption, the policy response for lifting US savings is cutting the US budget deficit. Officials across G7 have welcomed the Bush administration's relatively new concern over reducing the budget deficit by trimming spending. This line of reasoning is mainly wishful thinking. The reality is the US budget deficit will likely grow to over $500bln in the new fiscal year up from $412bln in the last fiscal year. War expense, Congressional reluctance to cut spending, a four year record of no presidential vetoes on spending bills, costly war on terror, Medicare prescription drug funding liabilities and ambitious and costly tax and social security reforms suggest a blow out in the deficit as far as the eye can see. Until Washington in general starts talking about tax increases, I am a seller of budget deficit reduction. Even the GAO's David Walker today warned of huge unfunded liabilities, including unfunded Medicare drug prescription benefits ahead mand the concern of foreign investors over the US budget deficit outlook...said it will weaken the dollar if not adequately addressed.

So where am I in the cyclical-structural spectrum regarding the dollar? My dynamic model (wet finger in the air) sees the structural theme outweighing the cyclical theme and driving the dollar lower. The cyclical theme however is strong enough to prevent a dollar long as the US economy remains robust and can sustain higher short- and long-term rates. But if the cyclical story turns negative for the dollar, all bets are off...a dollar crisis would be likely if not unavoidable.

Clearly, the balance of market views is far from my position...if not euro/dlr would be at 1.40 by now. And there is enough life in the dollar bulls focused positive US cyclical fundamentals that for the time being, the 1.27-1.36 range looks like a temporary equilibrium. But this resolves higher (lower dollar) and look for next thrust higher once US February payrolls (March04) are out of the way. I am sticking to 1.45 euro/dollar high this year and could come as early as the summer.

David Gilmore


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