Last month I ended by saying that I expected the euro and the yen to continue to appreciate against the US dollar. Well, it was not long after that the greenback began a big rally against other major trading currencies. Rather than eat my words, I want to explain what this means and whether the dollar revival will last.
My key global investment theme has been that the credit crunch would cause credit to contract, causing global recession. But I recently added a coda that energy and other commodity prices (in which we were short) would collapse as a result, causing headline inflation to plummet towards the core rate in rich countries and restoring some modicum of purchasing power in the even harder-hit emerging markets.
This would restore some measure of freedom to central bankers. Markets would love that. Risk assets would have a big rally. And the dollar is also a risk asset.
The catalyst for the recent dollar rally was the European Central Bank’s shift in rhetoric at its last rate meeting to recognize that the eurozone economy is tanking.
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G4 central bank real policy rates |
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From 1999 to 2008 |
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Source: Datastream |
The significance is that the ECB won’t raise policy rates any more. It eliminates the policy divide between the Federal Reserve and ECB – at least in investors’ minds. The euro thus loses the support of any expected widening of the policy rate gap between the US and the eurozone.
The current dollar rally has further to go. What are the drivers for it?
The first is the narrowing US current account deficit. This has already been declining and should fall to under 4% of GDP in 2008. The caveat is that two-thirds of the improvement in the non-oil trade balance has been driven by weak imports, not rising exports, where the US continues to lose global market share.
Falling imports are the result of the slowdown and oncoming recession in the US economy. When the US economy recovers, the problem of the external deficit and how to finance it will return. And, as a percentage of GDP, the US deficit will remain the biggest in the G7 (along with the UK) despite this cyclical improvement.
However, in a growthless world, investor expectations that the US economy could recover faster than its peers increases expectations of earlier Fed tightening. This will strengthen the dollar for a while.
Second, falling oil prices, say to $80 a barrel, are seen as highly favourable to US inflation and consumer incomes (causing about a 1% gain in purchasing power). It is perceived as a big boost to trade performance, too, even though I reckon the real impact of such an oil price decline on the US external deficit would be only about 0.35% of GDP.
The third support for the dollar is monetary conditions. Taking long-term and short-term interest rates, exchange rates and equity market conditions, eurozone monetary conditions are extraordinarily tight and the US’s are fairly weak. Fiscal conditions tell the same story, with a dramatic worsening of the budget deficit in the US under way, significantly as a result of measures to ease the pain of the credit crunch, while there is stasis in Europe.
These monetary and fiscal conditions reflect vastly different levels of policy support for the economy in the US and Europe. I reckon that the soft option policies of the US administration are wrong and will exact a high cost in growth and inflation. But, in the short term, the policy gap between the eurozone and the US is more likely to breed optimism in an earlier recovery in the US economy. This will strengthen the dollar.
The final factor is that the market is still massively short the greenback. Given that US short-term rates are so low, the borrowed dollar has become the source of financing for umpteen carry trades into higher-yielding currencies and non-dollar financial assets in the past year. It will take a long time for these positions to be unwound.
Many of these themes for a continuing dollar rally are linked to market hope for US economic recovery. I don’t think the US economy will recover in the way the market is likely to believe. However, at the margin, disappointment about economic activity is likely to be greater in the case of Europe and Japan than for the US. This will narrow expected eurozone and Japanese interest-rate differentials over the US. That is enough to sustain the dollar rally for a while.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com