Foreign Exchange Insights

May 9, 2008

It’s much easier to spot an asset bubble than to predict when it will deflate. Commodity markets in general and oil prices in particular display the typical characteristics of a bubble. Asset bubbles always have a fundamental basis in their early stages before a bubble in fact exists. The bubble develops when market exuberance transforms a sensible directional movement into unsustainable extremes. The unsustainability most times gets corrected far later than the point where objective analysis suggests “enough is enough.” That’s what makes exuberance irrational to the analyst’s eye. Oil prices are 8.1% higher than at the close last Friday and 104.4% above the level prevailing one year ago. Gold prices have climbed 76% during the past 12 months. Commodities get bid up when investors fear inflation and when global demand outstrips supply. Commodities also provide feedback on monetary policy, rising when the stance of the Fed seems excessively accommodative to preserve acceptably low inflation in the medium term and too loose to ensure confidence in the dollar’s long-term store of value.

The biggest financial market killings go to the investor, who anticipates a bursting bubble just ahead of the event. However, a strategy that assumes a bubble is about to burst carries risk if the bubble instead continues, and that possibility happens more frequently than instances where a bubble reversal is anticipated in a very timely manner. I believe that commodity prices ought to correct lower. But I am not willing to stand in front of that train and would not be shocked to see oil and gold inflate signficantly further before a correction in fact occurs.

Upward pressure on commodities constrain the dollar’s scope for recovery. Even when the dollar was advancing in the week to May 2nd, investors were uneasy because of the continuing incline of commodity prices like oil. Sure enough, the dollar experienced a more difficult time this past week, although it failed to decline across the board. There were advances of about 1.5% against the kiwi and British pound and an insignificant net change relative to the euro. But drops of 2.1% against the yen and 1.2% against the Swiss franc — both proven hard currencies — and 1.1% against the currency of Canada — where America has considerable trade and financial ties — qualifies the past five days as a bad week.

The case for a dollar reversal has holes. The argument rests on two pillars. One points to the objection of G7 officials to continuing depreciation, and the other rests on the premise that economic growth and hence monetary policies between the United States on the one hand and other key countries on the other are converging. Consider the second point first. The United States avoided negative growth in 4Q07 and 1Q08 and likely will do so again in 2Q08. With a new operative word of “pause,” the FOMC is unlikely to cut rates in June. But conventional wisdom is still betting that the 2.0% Federal funds rate does not represent the cyclical trough. A pause is just that, a temporary break in trend. Outside the United States, growth has indeed slowed, but central banks are not reducing rates in response because inflation is presently excessive and price risks are skewed to the upside. Policy signals last week from the Bank of England, ECB, Reserve Bank of Australia, Bank of Korea, Reserve Bank of New Zealand, and Swedish Riksbank also accentuated caution in the face of inflation. The U.S. has a negative real Fed funds rate (2.0% nominal minus 4.0% on-year CPI inflation) to set against comparable benchmark real rates of +0.7% in Euroland,+2.5% in Britain, +3.1% in Australia, +1.6% in Canada, and -0.5% in Japan.

G7 officials were right to escalate their protest against recent dollar depreciation. The influence that officials have over currency markets is grossly under-rated especially in the short term where the new wording in the early April G7 statement has already produced desirable results. But this is a situation where the emperor to some extent has no clothes, and that is why the new language stopped well short of a call for a reversal of dollar depreciation. History shows that it is harder tactically to halt a long-term currency trend than to reverse one. The problem now is that fundamentals are still not very dollar-supportive. Commodity costs are rising, the risk of recession is greater in the United States than elsewhere, and adverse interest rate spreads are not likely to change much. Officials are merely hoping to create greater two-sided dollar risk, and that is an achievable goal. Keys are to keep the euro from challenging $1.60 and the yen from strengthening through 100 per dollar.

This past week did not offer investors much data to absorb, but the data calendar is very heavy for next week. !Q08 GDP figures arrive on Thursday-Friday from Japan, Germany, France and Euroland. Britain announces CPI, PPI, wages, and unemployment, plus the Bank of England publishes its quarterly inflation report. Euroland industrial production, and Japanese consumer confidence and Economy-Watcher’s Index are due, too. From the United States, we get the monthly Federal deficit, retail sales, consumer prices, Treasury TIC figures, industrial production, N.Y. and Philadelphia Fed district factory indices, NAHB, housing starts and consumer sentiment. Many speeches are planned for Fed officials, and both Chairman Bernanke and ECB President Trichet will be speaking on Thursday.

Investors must ask themselves if a significant relative improvement of the U.S. economic outlook compared to prospects in Japan and Europe is fact or imagined. Even more important will be a need to separate growth prospects from the outlook for inflation, because the latter is the bottom line for policy-makers in many central banks. And finally, what happens to commodities and equities will influence intra-day movements in the major currencies as well as bias perceptions about the medium-term appeal of various currencies.

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