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Sunday December 18, 2005 - 23:31:45 GMT
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Contagion Contained, Not A Weak Dollar Trade/Trend Yet

Day three into a nasty round of contagion across the currency market (and gold...arguably now a quazi currency) has seen more bloodletting, especially for the kiwi/yen cross owners. But all in, the contagion is confined. Sure, the Nikkei longs have felt some heat as the yen spike hurt exporter stocks. But even here the losses have been relatively modest. And looking at the emerging markets, one can see that debt and equity markets in this silo have not experienced anything that could remotely be called contagion-related liquidation. Moreover, the fixed income market generally speaking has not seen a huge flow to the safety of AAA-rated government debt. Credit derivatives market where there is still large exposure in the hedge fund land has also been fairly calm - corporate spreads remain tight as well. Again the leveraged fund community is still on a yield binge and locked into some hefty exposure in the high yield market. Pain on the currency and precious metal side of the spreadsheet of risk has not translated into much activity in the high yield portfolio. I am not suggesting broader contagion is not possible...risk is higher than in any point in months. It just isn't showing up outside the obvious assets and currencies mentioned above. It (broader contagion) does bear watching, though no alarms need raising now.

For those ready to throw the strong dollar out with the carry-trade bath water, it may be best to step back a bit and look at what has happened to the dollar outside of dlr/yen? Not much. Euro, chf, C$ and stg are up vs. the dlr but not by much. Don't read a position flush as a sign of a turn in the USD. I am not saying a bear mkt is not in the cards for the dollar. Indeed I have said all along that the dollar will resolve in a major bear trade when the US economic cycle turns south. The jump in US capacity utilization to over 80% is consistent with reduced capacity (Fed used to use 82% as threshold for bottlenecks). This would argue that the Fed's experience with a neutral policy stance is nothing more than the 6 weeks between FOMC meetings - move right to restrictive. Sure, capacity utilization is not sufficient evidence to prompt the Fed to get restrictive. But it won't take a huge leap of faith to imagine circumstances in Q1, together with little to no excess capacity, that would argue in favor of the Fed adopting a restrictive policy stance. For the sake of the housing market and consumer-driven growth I hope this is not necessary.

One thing I can say reasonably confidently about the cyclical story and the dollar that suggests struggle to achieve new highs in 2006...13 rate hikes into the expansion and tightening cycle is not thematically as favorable for the dollar as say 10 rate hikes into the cycle. And especially not as favorable in light of tightening cycles, however modest, underway in the Euro Zone, Canada, Switzerland and Scandinavia. Bottom line, the cyclical story favoring the dlr is lessening, but we are a long way from markets embracing a weak dollar both cyclically and fundamentally. And it would be wrong to confuse risk reduction in carry trades with a turning point (lower) in the dollar. My bet is dollar carves out a range through Q1 with risk of modest new highs, and then begins to weaken with signs the US economy is slowing - by summer. Finally, with the US current account deficit expected to near $800bln this year (Q3 reported Friday and seen at over $200bln), officials from US Treasury to G7 to the IMF have to start thinking about the best way to manage (more like cope with adjustment risks) the adjustment process to reduce the chance of a disorderly adjustment in 2006. A slower US economy will help, as will an orderly decline in the dollar. I find it quite conceivable that at the Feb G7 meeting we could see a more deliberate attempt to talk the dollar down versus the Asian currencies first and foremost. The question is will Asia cooperate and let their currencies appreciate? So far the answer has been no. But sanctions lie in wait, for China anyway, if the dollar is not allowed to depreciate versus the region's currencies. The long Asia FX trade was not the right way to be in 2005 after all, but it is the right way to be in 2006.

David Gilmore


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