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Thursday April 14, 2005 - 15:30:37 GMT
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Dollar Defies Fundamentals...Dornbusch Would Have Said To Be Expected

Dollar Defies Fundamentals...Dornbusch Would Have Said To Be Expected

Who would have thunk it? The US posts a record trade deficit, prints a weak retail sales number, sees US Treasury yields decline and releases FOMC minutes that add little to the March22 statement and the dollar is higher. Not even warnings about unsustainable US imbalances from the IMF to NY Fed President Geithner can stick on the Teflon dollar. Indeed it is the un-Teflon euro where news seems to be sticking, like the growing likelihood that France votes non on the May29 referendum on the EU constitution. Buffet rumor aside, this market is flat out counterintuitive.

Which leads me to the late great thinker on currency crises...MIT Economist Rudi Dornbusch. UC Berkeley's Brad Delong summed up Dornbusch on how psychology in currency bubbles unfolds ahead of a currency crisis, with Dornbusch noting four distinct stages.

1. Enthusiastic investors and speculators chasing immediate short-term returns cause the anomaly to last for longer than economists expect.

2. Puzzled by the failure of prices to return to fundamentals or of unsustainable policies to generate a crisis, highly-intelligent economists evolve theories explaining that *this* time it really isn't unsustainable.

3. Fortified by these theories, yet more investors and speculators chasing short-term returns flood into the market, causing the anomaly to last for *much* *much* longer than economists had originally expected.

4. The supply of greater fools comes to a sudden end; the crash comes; the crisis comes.

Delong argued (last September) that we are in stage 2. Fed Governor Bernanke has theorized the US current account deficit is a by-product of a global savings glut implying this time is different...unsustainable is sustainable.

While I am not suggesting a dollar crisis is inevitable, the more markets snub the significance of the widening US external imbalance for the dollar, the more the odds are the adjustment will be disorderly.

When? Well clearly not right now and probably not Friday when US Treasury releases capital flow data for February are published. Especially when stages 3 and 4 have yet to be reached. And surely not when the un-Teflon euro has a possible French "non" vote in the EU constitution May29 sticking to it.

Throughout the dollar's decline, bullish US economic fundamentals have been a parachute for the dollar and more recently a thruster for a dollar bounce since the Fed became alarmed about inflation. However, the outlook for above-trend growth in the US led by consumer spending and assumptions about firm pricing power are increasingly questionable. If anything, the outlook for growth and prices is more uncertain now than at anytime since the US economy allegedly flirted with deflation. And at no time since have officials at the Fed and market pundits been so confident on the outlook for the economy and interest rates. So much so that the Fed has hand held the market through 6 rate hikes, clearly spelling out its intentions so as not to surprise anyone.

Well what if the Fed got it wrong? The rise in oil and commodity prices have not been transitory as asserted through much of 2004 (no longer I add). And what if the US consumer has dropped. That's right. Dropped from too much shopping. Income gains is not supporting ever more consumption. Home ATM machines have been tapped about as much as consumers are will to take out and banks willing to lend. And boomers are starting to think about retirement (a bit late, but this is the generation that is intent on defying aging).

A slower US economy has no safety net in stronger Europe and Japan economies...they are on US-import-life-support. And where is China as an engine for growth if the US consumer starts to save, or worse is forced to save?

Yeah the story I am telling will address the growth in the US current account deficit for sure. But in the near-term, the dollar is likely to get hit by a double whammy...record external deficit and deteriorating fundamentals...the parachute/thruster suddenly looks compromised. This would create a powerful downdraft for the dollar where global creditors reassess their willingness to indefinitely buy US assets.

I used to think (still sort of do think) that a spike in US interest rates (Treasury yields) would drive a disorderly adjustment...with a shift in investor preference and not inflation driving the move up in rates. But what if the US consumer is just done...without the jolt from a punishing rise in rates? Oil, age and flat spent/borrowed out. If there are is any consolation, a slowing US economy favors a more orderly adjustment than a spike in rates that takes apart the US real estate market and many household balance sheets. Either way the dollar has lots more lifting to do in the adjustment process despite the current round of denial.

David Gilmore


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