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Monday March 21, 2005 - 11:23:09 GMT
Black Swan Capital - www.blackswantrading.com

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Does this $ move have legs?

Quotable

“Typical traders to through the exercise of convincing themselves that they’re right before they get into a trade, because the alternative (being wrong) is simply unacceptable.”

Mark Douglas, Trading in the Zone

FX Trading

It seems more and more players are warming to the idea that higher US interest rates could be a dollar driver after. Maybe it’s because the US differential could widen a bit faster than expected not so long ago if the Fed shows concern on two fronts: rising inflation and assets bubble-ology.

But what’s interesting if you compare the US$ Index to 10-year T-note yields is that give or take the usual leads or lags, they tend to move together. But now a very wide gap has opened between the two suggesting the dollar (or bond yields) has overshot to the downside and…


Chart: $ Index vs. 10-year Treasury Bond futures

…we could be entering a whole new environment i.e. instead of the dollar rallying on money flow into bonds predicated on booming US financial markets (which is what spawned the dollar rally as the S&P 500 & Nasdaq blasted off in 1995), it could be a cold calculation of yield that drives money flow for the foreseeable future. This is especially true if the concern about structural problems is behind us (that would be an assumption too early to make, granted).

But, the dollar rally last week suggests the structural concerns may be on hold for a while. We are seeing two background themes gathering some support (rightly or wrongly):

1) The US is able to handle a budget deficit larger than once expected; from an article in the Financial Times this weekend,” Wolfgang Munchau: The dollar has fallen enough”:

In view of this consensus [the euro will take the brunt of dollar devaluation], the economists Pierre-Olivier Gourinchas, of University of California at Berkeley, and Hélène Rey, of Princeton University*, make two brave claims. First, they argue that the dollar's depreciation between 2002 and 2004 may have been sufficient to redress the imbalances in the US economy. Second, and most outrageously, they claim to have constructed a model that is better at predicting exchange rates than the "random walk" - under which the best forecast of the future exchange rate is today's exchange rate. It is no surprise that the latter result in particular has generated some excitement in the financial markets.

How do the authors come up with such different conclusions about the dollar's level? The US calculates the current account, including the trade balance, investment income and financial transfers, at historic cost. This calculation, however, may understate the return on net foreign assets - the difference between foreign assets held by the US and US assets held by foreigners.

Mr Gourinchas and Ms Rey undertook the task of disentangling the various classes of inward and outward investments and measuring their real rates of return. If these data were put into the current account, you would get a far more accurate measure of an economy's imbalance and, as it turns out, one that is far less dramatic.

2) Europeans are not as enamored with their so-called “Union” now that unemployment and growth has stagnated. The agreement to relax budget deficit rules proves the US isn’t the only place facing fiscal problems.

Bottom line: If the Fed does the right thing this week, and inflation data doesn’t disappoint, we could see this dollar rally show staying power. And if as we said last week, commodities react negatively to the Fed doing the right thing, the commodity dollars—especially the Aussie—could be in for a rough ride.

Jack Crooks

 

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