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Wednesday August 16, 2006 - 12:59:09 GMT
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Forex: FXA Alert. The Return Of The Secular Weak Dollar Trade

The Return Of The Secular Weak Dollar Trade

Events this fall should see the return of the secular weak dollar trade - resuming the move down that stalled in June (sterling however did break dollar lows after the recent BoE tightening).

Despite volatile inflation reports as witnessed in the July PPI report today, the Fed is looking much further down the road and pause is not taken lightly...if its forecast assumptions hold up it is the end of the tightening cycle. This is the key dollar negative for the second half of 2006 and we could see Fed easing in 2007 if the housing market comes unbuttoned...something that not even low long-term rates are capable of preventing. Indeed the FOMC is unlikely to seriously considering an 18th rate hike in the current tightening cycle until the late October meeting at the earliest. And the Fed's assumption that weak housing will translate into weak consumption is reasonable and warrants a wait-and-see approach to tightening. Furthermore, the one safety net that the Fed's soft landing assumption is predicted on is looking increasingly investment is a relative disappointment. Cash rich firms are not stepping up to the plate on capital improvements sensing the same thing the Fed senses - a vulnerable consumer. Why beef up capacity for a weakened consumer? Fortunately for the Fed exports are holding up and this safety net remains in place for the soft landing scenario panning out. But two nets are better than one.

The other key ingredient to the return of the weak dollar trade is the continued rate tightening for the ECB, BoE, RBA, SNB and BoJ. Rest assured that none of these central banks are considering a 2-yr tightening cycle, repeating the Fed's experience. But against a Fed on pause probably through year-end, the modest tightening abroad will be hard to ignore and it will close nominal spreads currently favoring the dollar. Sure in mid-2007, a sluggish US economy is not the best backdrop for European and Asian growth stories (emerging markets too). The single engine story is still compelling (China is very US dependent until it develops more of a domestic consumer-led economy). But there is a window for the comparative rate story too play out in favor of the ROW's currencies (rest of world) well into the 1Q of 2007.

G7 and the IMF meet again in mid-September in Singapore where imbalances and the adjustment process will again be highlighted. Indeed there has been little to no progress on the policy front to address imbalances since the April G7 and IMF meetings raising the risk and role for the dollar to shoulder the burden of adjustment (the dollar index is down about 5% from pre-April G7 levels). China has done nothing on its currency under valuation (vis a vis the dollar). Washington has done nothing to address low US savings. Europe is moving on a tortoise-like pace to address structural impediments to growth and Japan is still hardly the extreme makeover post-deflation economy. Look more the IMF to pound the table for a lower dollar than US Treasury or G7 in September - 15-35% dollar overvaluation according to last Article IV review out a few weeks ago. But with the dollar under pressure from deteriorating cyclicals, the imbalances theme will have far greater traction in financial markets by September.

Congress too will be moving on protectionist legislation by the end of September (Schumer-Graham Bill will go to a floor vote according to the bill sponsors). Clearly there will be lots of pressure on China to move ahead of G7 (Treasury Secretary Paulson will travel to China on his way to G7 in Singapore, as well as Japan). So even if China's political leadership determines some faster pace to appreciation for the yuan is a small price to pay for avoiding the protectionist wrath of Congress, a reval would be a catalyst for broader dollar gains vs Asian currencies in general.

And sticking to the US political dynamics, the mid-term elections in the US could see a significant shift in the composition of Congress in favor of the Democrats which would surely lower the odds of major supply-side tax reform, income tax cuts (making them permanent) and put record government spending in limbo. Gridlock arguably in Washington is a bullish environment for bonds and at times the dollar. However, I am looking at the political uncertainty of the mid-terms as a two round effect. First round should see US assets pressured (and the dollar) by fear of an empowering of the anti-business, anti-wealth-creation for the few Democrats. Second round effects of better checks and balances could yield benefits for US assets. But a Democratic win of both the House (most expected) and the Senate (least expected) would also throw open the entire White House to a permanent state of investigation and potentially presidential impeachment. This too will assure some negative first round effects emerging from the November Congressional elections.

Then there is the never ending geopolitical risks that are sure to keep oil prices high if not higher...Iran and its nuclear "power" program will be taken up by the UN Security Council in earnest in September. Iran has threatened it will stop selling oil to the world market and even close the Straits of Hormuz if sanctions are imposed on the country by the UN. North Korea too remains a simmering cauldron of uncertainty which indirectly gives China, North Korea's only ally, a major bargaining chip...on Iran and the yuan. Israel and Hizbollah have massive unfinished business that make the current ceasefire very unstable. Oil shocks have always fuelled inflation, but the killer was always what they did to growth. Fortunately most Americans were alive during the 70's and 80's and still believe in the Volckerized Fed. Wage price spirals from unaddressed inflation and rampant inflation worries is not in the cards. So I am keeping oil in the growth sites ahead and not getting sucked into the hyper-inflation camp.

For the time being the dollar is likely to remain rangy with low volatility. The market is still structurally short dollars and there is a strong argument that more of the weak dollar shorts need to cover before market supply-and-demand conditions are conducive to a major launch pad for a multi month secular dollar decline. I like buying euro/dollar at 1.25 for 1.40 by end 1Q 2007.

David Gilmore


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