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Friday March 17, 2006 - 14:09:01 GMT
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Forex: Cyclical And Structural Themes Merging Against Dollar?

Well not exactly. Not yet anyway. Don't get me wrong, the dollar has broken significant levels and has plenty of scope to run lower in the next 6 weeks. But this is not Armageddon Day for the dollar. The major long-term sell-off will not come until the US economy shows signs of slowing and the Fed is seen cutting rates not raising them. I have pounded the table for two years that the dollar is vulnerable to the confluence of a weakening economy and an unsustainable current account deficit. The economy did not slow in the face of record nominal oil prices as forecast and cheap money supported US and global housing markets which in turn supported US consumption.

The US inflation data Thursday are not going to make the Fed pause any sooner in its tightening cycle. The data showed no change in y/y core CPI (2.1%) and remained above the comfort zone for the Fed, though the more closely followed core PCE price index remains just under 2%. And there is nothing in the data to suggest the economy is slowing apart from some moderation in housing. The labor market looks solid and the consumer is still quite happy dissaving.

What is different on the cyclical front and yes warrants some dollar selling, is that the outlook for Fed funds is considerably less certain than it has been at any time in the last couple of years. It is quite possible that the Fed raises rates March 28 and pauses, if there is greater indication of broader moderation in the real economy and core inflation measures turn lower rather than do what they are currently doing which is stabilizing. As Greg Ip said on CNBC Thursday, his Fed sources see a greater risk of Fed tightening ahead than of the Fed pausing. Yellen who started this latest round of pause-think in the markets when she warned the Fed had to b worried about the risk of overshooting on rates, came back earlier today and said she was uncomfortable with core inflation at the upper end of the comfort zone.

Essentially markets have gone from thinking they know what the Fed will do at the next two meetings Mar27-28 and May10 to knowing what the Fed will do Mar27-28 and not knowing what it will do May10. The Fed does not know either and they have been saying as much since the start if the year. The only surprise is that it took the markets this long to get the message...when the data have not really changed much - strong growth and low inflation.

What is new is the evidence of greater deterioration in US external balances as shown this week in the record Q4 current account deficit (now over 7% of GDP and rising) and record monthly trade deficit for January reported last week.

What else is different is that the US Treasury seems to mind. How do we know this? Tim Adams, the Under Secretary of Treasury for International Affairs, told MoF in Tokyo nearly two weeks ago that Japan should not prevent a rise in its currency which implied an assumption that US Treasury thinks the conditions are in place for the dollar to decline versus the yen (shift in Japanese monetary policy and an improving domestic economy). When was the last time a Treasury official said anything about the yen or even cared about FX apart from the yuan? Sadly the market has forgotten that US Treasury can influence currencies. And Adams is putting Treasury back on the currency market map of significance...believe me. He is the un-Taylor at Treasury.

The Bush administration needs to stay ahead of Congress on trade issues and one can easily see where public and legislator emotions will run to if Ford and or GM file for Chapter 11 in the next 6 months (a very real risk) only to see Toyota Camry as the most popular car sold in the US. Remember Andrew Card - Bush's Chief of Staff? He was a lobbyist for the US automakers for a number of years during the Clinton terms and he squawked frequently to the press and White House at that time about an undervalued yen and a yen manipulated by MoF.

While the Bush administration is unlikely to embrace a weak dollar policy or even shed the strong dollar policy for a benign dollar policy, it has to think that an orderly decline in the dollar is a good thing...a weaker dollar against most currencies is a good thing. It will help stem the protectionist drift in Congress that really threatens the global trading system, economy and financial markets, and it is an insurance policy against a potentially disorderly dollar decline later assuming markets do indeed find US imbalances unsustainable and foreign capital inflows, slow, dry up and even reverse. The difficult task is how to signal this desire and not generate a market reaction that tends toward disorderly. Surely a Plaza-like accord April22 would risk unraveling the current equilibrium and could kill the global expansion if it got out of control. But a gentle tap on the shoulder of the market that the dollar should trade lower to begin to aid the adjustment process (not the means to an end...but insurance against a disorderly decline later) is needed. We know imbalances are on the G7 agenda front and center and we know that there is a growing consensus among officials (more among central bankers than finance ministers) that with the sun shining it may be best to nudge markets in the direction of adjustment rather than wait for the markets to get there on there own when it may be too late to avoid the disorderly adjustment). Europe is standing in its own two feet (maybe kneeling) and Japan too is now in a sustainable recovery phase. It is time for burden sharing.

So if I were short dollars which I would be if I traded, I would be doing so based on the bet that between now and end of April the markets will be brought to the trough of structural imbalances by officials and the discreet G7 sign post will point toward an orderly dollar decline. I would not be short dollars yet on the notion the US cyclical outlook has changed significantly to the detriment of the dollar (nor equally that the outlook for Europe and Japan have radically improved of late). I would be slightly dollar bearish on the notion that the outlook for Fed funds is uncertain after being quite certain for most of the last two years while the outlook for official rates in the Euro Zone and Japan are quite certain for the foreseeable future.

But the power trade down in the dollar will need a marked slowing in the US economy and that starts with the consumer turned off by a weakening housing sector. Yes higher household savings will ultimately bring about the adjustment in the trade account and stabilize the dollar. But the early phase of adjustment will see the dollar fall as the economy slows even with rising household savings...the key mechanism for trade adjustment.

David Gilmore


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