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Tuesday April 4, 2006 - 15:10:32 GMT
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Forex: Weak Dollar Trade Closer

Since Q4 2005 I have put a major weakening in the dollar in the 2H of the year, based mostly on the notion that Europe and Japan would not quicken their respective expansions soon enough and the US economy would slow by late summer and into year-end behind a weakening housing sector.

That said I think we are near a point this month that could see the early arrival of the weak dollar trade. Forget for a moment that this trade has been a favorite of macro hedge fund managers but has to date only been a disappointing bet as range, not directional, trading for the dollar has prevailed.

First of all my call for a weaker dollar in the second half of this year was based on my belief that the path to the big bear dollar trade was through a shift in the cyclical theme. In other words some significant slowing in the US economy would lead to a weaker dollar and draw the attention of the market to record imbalances...the confluence of the structural and cyclical themes both pointing to a lower dollar.

But I think there is a reasonable chance that this trade unfolds earlier ... as in April.

Why? Well my prior assumption also banked on not much change in economic activity in Europe and Japan and a relatively benign attitude about imbalances from G7 officials. Both these assumptions are proving to be wrong. Data from Europe and Japan have been promising, even suggesting recovering domestic demand and business investment (forget structural reform as France's labor problem has shown) - more than simply export-led recoveries. G7 officials are far more concerned about US imbalances than I previously believed and this concern is rising to the point where some action may be forthcoming. Indeed look for the imbalances theme to get loads of attention at G7 meeting in Washington April 21.

While it is hard to imagine MoF or Eurogroup embracing the need for yen and euro appreciation, it is no mystery that central bankers and dare I say some US officials see a lower dollar as a necessary outcome of an orderly adjustment. Indeed there is also a consensus within this group, arrived at independently I believe, that the longer the adjustment process is delayed, the greater the risk of a disorderly adjustment (dollar crisis scenario no more eloquently outlined than by NYU's Roubini, and more recently by none other than Bank of Canada Governor Dodge and NY Fed President Geithner).

Why now? Do it when the sun is shining. US growth is strong, the Fed is still raising rates and domestic demand is taking root in Japan and Europe. Moreover, waiting for markets to deal with imbalances after it is clear the Fed tightening cycle has ended and it is in its early stages in Europe and Japan would elevate the disorderly dollar adjustment (begets interest rates - Treasury yields spike) that so many officials fear. And official and market rates are rising in Europe and Japan.

Protectionist politics in the US and Euro Zone in particular are taking root like weeds. This crowd will sooner than later hijack the currency issue (already has happened to a degree in the US with Senators Schumer and Graham, and surely we are not far off from when Ford and GM demand a stronger yen). It is high time to beat this crowd to the punch and keep currency politics at the treasury or finance ministry level and out of legislators' hands.

G7 has periodically tapped the FX market on the shoulder and said this way boys and girls. Plaza and Louvre were more like using a Taser gun on the market...but Rubin's dollar mantra and dollar mantra variation (strong dollar is in us interest, the dollar has been strong for some time) was more tapping than administering a cattle prod.

Sure, few G7 officials outside Japan in recent years welcome verbal interventions in FX. But a case can be made that if the dollar starts the adjustment process now (April 21) it could enhance the odds of an orderly adjustment. The dollar will surely not be the mechanism for adjustment (rise in US savings will be), but its psychological impact would be much desirable. An orderly adjustment down in the dollar now would lessen the risk of a disorderly decline later when foreign investors turn on US assets bas risk aversion spikes. There is some concern real and imagined that if the G7 now said - okay dollar needs to weaken that it would fall off the cliff even without a major slowdown in US growth. But arguably the safety net is in place now in the form of reasonable net capital inflows to the US, bullish US fundamentals, highest Treasury yields since the Fed started tightening in June 2004, Fed still tightening and multi-year highs in US equities.

Okay G7 hardly does anything of significance and hence the easy call this month is for G7 to leave structural reform as the desired path to ending imbalances or when hell freezes over. But I find this sort of analysis useless. If everything that happened before will happen again then we do not need people like myself to give advice and promote possible outcomes. Fortunately every once in a while the less predictable outcomes emerge and markets adjust. This is one of those times...I believe...and at the risk of being wrong no doubt.

And it is reasonable to expect European and Japanese finance ministers to oppose any hint of the need for a higher euro or yen at G7. But just maybe they will see the alternative - doing nothing elevates the risk of a disorderly adjustment later. Think of it like the approach the Fed had toward deflation...the risk of a disorderly adjustment to global imbalances is low but it is also comes at an unacceptably high price necessitating some insurance or the building of a firewall.

Lastly, since September of 2003 G7 has made China the main focus of its currency cooperation program and with mixed results...China's yuan is about 3% higher vs the US$ since July 21, 2005 when the first 2.1% revaluation occurred, and yes Asian regional currencies are up more substantially with the exception of the yen. But there is no need to limit all currency adjustment to the yuan...China may move a bit here and a bit there but it is not going to unlock the global currency markets to an orderly broad adjustment down in the dollar. It is high time that G7 steps up to the plate and no sooner than April 21. And if European and Japanese officials succeed in keeping the FX policy the same - only problem is the yuan - then the US Treasury's approach should be two-fold. First signal desire for an orderly adjustment in the dollar (for that matter call for orderly move up in non-dollar major currencies) and enlist the IMF to do the
...something the rhetoric of its Directors suggest would be a given.

David Gilmore


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