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Dollar View - Lower is Back

Dollar View - Lower is Back

Lower is back. And it happened ahead of the all important (for the Fed and markets if not me) May employment report (read change in payrolls). As euro/dollar broke above 1.22 last week, prices spoke volumes about market psychology and the return of the structural story/theme that led the dollar lower through February of this year. Okay few are mentioning the US current account deficit when describing why the dollar is lower. Indeed, most are citing rising oil prices slowing the US economy, reducing the need for the Fed tighten, when explaining why the dollar is weak. And more recently the weakness in the yen has been attributed to oil prices. A few thinking about the second order question recognize this oil "shock" is not specifically a US problem but a problem for all major oil importing nations and economies. Surely if the euro were to weaken more markedly the collective explanation would be oil. At best the oil story is chasing price.

How about a new way to think about oil and FX? Higher oil prices for countries running large external imbalances bumps up the import bill and worsens the balance of payments (need more foreign capital inflow). So from BoP basis, all else being equal, higher oil prices should pose greater downside risks to currencies of countries running large external imbalances. But this is surely something that is seen over months and years and not days or weeks.

And I am mentioning basic macroeconomic theory, much as theory notes rising rates relative to the rest of the world, all else being equal, should attract more foreign capital and see the currency appreciate. Is this not why in part the dollar rallied from April...after strong March jobs and subsequent shift in the Fed's FOMC statement language (dropping considerable period). Moreover, markets are forward looking and discount changes in monetary policy in advance of the actual policy shifts. The short end of the yield curve has discounted over 100 basis points of tightening the rest of the year. It is in the dollar level. And we know the reality of FX markets, beyond a tendency toward randomness at times, that interest rate hikes do not always yield a stronger currency...recent monetary history is littered with examples of currency crises when higher rates yielded more selling. And in the case of the Fed's 300 bps in rate hikes from February of 1993 to February of 1994, the dollar was largely lower. One could argue that in recent years monetary policy tightening tends to support a currency through the initial moves/signals of higher rates, and then ceases to support the currency (is quickly discounted and other factors dominate).

But at the end of the day why is less important than what is, and what is is the dollar is weakening and market participants will find reasons to justify selling dollars. Oil today, terrorism tomorrow (even terrorist strikes in Europe as Madrid proved, albeit on a small scale), weak May payrolls the day after tomorrow. My point is the market is ready to sell dollars. It is not short, on balance. It is selling dollars with less than spectacular fundamentals stories in Europe and Japan. It is selling dollars in a global economic environment where near unprecedented monetary accommodation is slowly being removed. It is selling dollars when the US productivity story is still quite remarkable (high growth rates, if coming down). And just maybe the collective pool of world savers has had enough of US assets and is less eager to load up on more as is necessitated by low US savings. Investors may not be enamored with the prospects for European assets and the European economic performance (expected returns), but may simply be selling dollars on a defensive basis to hedge FX risk on existing US holdings or liquidating pieces of the US portfolio. However, the truth may be even simpler...less new capital is being committed to US assets and this suggests a gradual dollar decline and higher US market rates in coming months.

Will Asian central banks fight this trend? No doubt they will and may in part succeed (at a cost...amassing ever more US assets). But Japan will not be accumulating dollars in the scale seen earlier this year and in 2003 for that matter. Furthermore, China will relax its currency peg which in theory will reduce the need for absorbing dollars and US assets.

And official US attitudes on the dollar? Well the Fed has become more vocal about the dollar and adjustment in the last year, arguably embracing the orderly dollar decline as the recovery failed to generate jobs and inflation was low. But with inflation more in sight and jobs growth showing up in payrolls since the March data in early April, the Fed may be less enthusiastic about continued dollar weakness ahead. That said the dollar is well down the list of factors motivating Fed policy and will not drive the timing, pace or size of rate hikes ahead, short of a collapsing dollar.

At Treasury, where the dollar does matter and where the administration "controls" exchange rate policy, there is not much to say. It continues to believe that the markets should be left to set the level, direction and pace. And short of a disorderly decline that threatened US asset prices in a significant way, do not expect much guidance on the dollar from US Treasury or the White House. Lower is still okay, higher is not a problem either (would be seen sign of confidence in the US and US economic policy, much as Fed rate hike is) and stable works too. The last time the dollar was a focus for Treasury was at Boca Raton and before that the Dubai G7 meetings. And it was only a focus because others made it a focus...others as in Europe and Japan (as well as China). None of that concern is evident today. So I would not worry about an orderly dollar decline ahead drawing out official US protests from the Fed much less the Treasury. And with economic fundamental less than impressive in Europe and Japan, look for the decline to be orderly...new euro/dollar high should be seen above 1.2930 (1.3500) ahead.

David Gilmore
FXA

 

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