Foreign Exchange Insights: July 2, 2008

July 2, 2008

A contrarian views is gaining traction at midyear that the dollar may perform much better than feared especially against the euro in the second half of 2008.  In my experience, foreign exchange forecasts that take a non-consensus view need to be taken seriously.  These forecasts turn out correct surprisingly often, suggesting that one can do a lot worse than simply trading against the crowd on a consistent basis.  Dollar bulls make several arguments.

  1. In very difficult fundamental economic circumstances, the dollar held its own last quarter.  In comparisons of this week’s lows to 1Q08 closing levels, the U.S. currency was down just 0.7% against the euro and 0.8% versus the pound but higher by 5.3% against the yen and 2.0% against both the Canadian dollar and Swiss franc.  The buck’s worst performance was a slide of 5.5% against the commodity-charged Australian dollar.
  2. G7 officials have thrown down the gauntlet against excessive dollar weakness. They will not tolerate a significant drop.
  3. The euro area economy is looking worse, while U.S. growth appears to have been better last quarter than in either 4Q07 or 1Q08. 
  4. A rate increase this week by the ECB may be that bank’s last hurrah, while the FOMC seems to be transitioning from rate cutting to rate raising. 
  5. Oil is part of a commodity bubble ready to burst.

I  need to see more evidence before joining the dollar bull bandwagon.  Since the late 1960’s when pressure to devalue the dollar began to build, the burden of proof has belonged to those projecting a stronger dollar.  The two intervals of sustained dollar appreciation occurred under very unusual circumstances.  The early 1980’s saw an extreme policy mix of very loose fiscal policy with a very tight monetary policy that resulted in high real U.S. interest rates and a substantial reduction of inflation.  The latter 1990’s saw a technology-inspired surge in U.S. productivity, which was sustained over several years but not forever.  Rapid globalization also contained inflation during this second period, but now globalization is on balance augmenting price strains.  Being weak more often than not does not preclude corrections of limited duration in which the dollar spikes upward.  Such a correction occurred in 2005.  A less dramatic opportunity for the market to shake out speculative positions occurred last quarter when the dollar stabilized.  Corrections usually follow periods marked by strong directional movement.  G7 officials have notched up the level of voiced concern about the dollar and likely will reinforce that shift when the group’s top political leaders hold their annual summit at the end of next week in Japan.  However, it would be surprising to see the Bush Administration intervene anytime in its final months when it was ideologically opposed to using that policy tool during its first 7-1/2 years.  The U.S. presidential party conventions  this quarter, especially the Democratic nomination of Barack Obama in Denver, will put the spotlight on the dollar’s vulnerability to rising U.S. trade protectionism.  Neglectful currency management is a form of protectionism, and it is likely to be focused mainly on the dollar’s relationships with currencies in Asia.  Among G7 currencies, the yen is conspicuously undervalued.

Dollar health in 2H08 will hinge importantly on the state of the global economy.  The U.S., Europe, and Japan muddled through the second quarter as a 21% surge in oil prices, rising food costs, higher long-term interest rates, sinking equity markets, and very depressed conditions in a number of national housing markets piled on top of the persistent reluctance of banks to make loans.  Britain, Spain, Italy, and New Zealand are attracting special concerns.  Germany, which has shouldered much of Euroland’s growth burden but is also now slowing, will be releasing the usual early-month batch of data on industrial output, orders, and trade flows.  French and Italian industrial output figures arrive next week, while Japan reports its economy watchers index, machinery orders, and consumer confidence.  From Britain, we’ll get industrial output, consumer confidence, trade and more information on imploding house prices.  The Bank of England is unlikely to cut rates on the 10th, while the Bank of Korea probably will raise them.

Many upcoming economic reports will be disappointing, and the thinking is that such news will support the dollar.  As Treasury Secretary Paulson insists, it’s a tough economic situation for everybody.  Why sell the dollar which has comparatively good long-term fundamentals according to the Secretary?  But what if the global outlook is in fact more precarious than realized?  Governments and central bankers have held to a reasonably upbeat long-term view.  They argue that sub-trend growth and flat-to-falling commodity prices will eventually reduce inflation, while macroeconomic policy support prevents or greatly mitigates the adverse risks to growth.  It may take four to six quarters, but there is light at the end of the tunnel. 

The annual report of the Bank for International Settlements, released on Monday, is much less hopeful about the future.  The BIS is no fringe think tank looking to make sensational headlines.  It’s considered the central bank for central bankers and commands considerable respect.  The annual report claims that irresponsibly loose monetary policies have been engaged too often and for too long to handle crisis after crisis, resulting in too much debt because inflation-adjusted interest rates that were plainly too low.  The BIS identifies no good policy options from here.  It recommends higher interest rates in the short run to address inflation even though such might amplify downside growth risks.  Ideally, tighter monetary policy would be offset by looser fiscal policy, but the BIS finds too many governments not in a positions to make that switch because of bloated budget deficits and accrued public debt.  On current policy trends, the danger is that inflation keeps worsening, and then paradoxically a deeper and lengthier global downturn could ensue.  By ignoring inflation now, deflation becomes possible down the road.  The objects of BIS scorn are presumably high-flying Asian emerging markets and the Fed.  The report is a counter-argument to Alan Greenspan’s Age of Turbulence, which defends virtually every major decision that he made and the libertarian principles that guided his thinking.  If Western civilization gets another chance, the people at the BIS suggest that monetary officials not tolerate the build-up of credit excesses so easily ever again.

The contrarian view has its best chance for a correct call if global economic trends in 2H08 turn out better than present consensus expectations, In the opposite circumstances, I expect the dollar to have a harder, not easier, time.  Fed policy has been less appropriate than ECB policy.  Stagflation generally breeds protectionist legislation.  The U.S. enters this period with big imbalances in the Federal budget, current account, and savings rate.  A new administration takes over Washington next January and is likely to commit rookie dollar management errors, just as new administrations have done over and over in the past.  The dollar still dominates reserve currency portfolios.  In times of stress, it will be the easiest speculative target.  The yen in particular seems overdue for a rise.


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