Richard Kapsch
November 6, 2009
The Dollar staged a bit of a rally in the past two weeks. Fundamentals regarding the Dollar remain negative, but we feel the likelihood of a major correction is too great to warrant continued Dollar selling. Nor do we foresee a Dollar collapse.
Introduction
On Monday, October 26, the US Dollar hit a 14-month low against the Euro, falling to $1.5061 per Euro. In the two weeks since, however, the Dollar has staged a mild recovery, rising to a one-month high last Monday (to $1.4730) before slipping again the rest of the week. It closed Friday at $1.4847 per Euro. Meanwhile stocks turned in a robust performance with both the Dow and the S&P gaining 3.2 percent in the week, closing at 10,023.42 and 1069.30, respectively.
Background
The Dollar had been in a virtual free-fall since early March when investors started buying equities as well as all sorts of risky assets in the belief that efforts of governments and central banks around the world would produce a rapid and strong global economic recovery.
There were a number of factors that had contributed to the Dollar weakness during this period. First, the US Federal Reserve was more aggressive than its counterparts in reducing interest rates, meaning that interest rate differential moved in favor of foreign currencies, most notably the Euro, Swiss Franc and British Pound. The Euro and Swiss Franc both experienced substantial upward movements vs. the Dollar. The British Pound, because of its own internal problems, was not as strong.
Second, as international investors moved into risky assets, there was less desire, on the part of investors, to seek out "safe havens" for their funds: in the months immediately following the Lehman Brothers collapse in September 2008, investors poured money into US Treasury Bills, the safest investments on the horizon, pushing up the Dollar in the process. The Dollar's diminished status as a safe-haven currency, after March 9, sent the US currency lower.
Third, as economies around the globe began to recover, the US economy seemed to be moving in low gear. Stimulus packages in Europe, especially in Germany, appeared to generate faster growth than in the US. And China was in a class by itself. By the second quarter, China's economy was recovering at an 8-percent (annualized) rate. Investors had better alternatives than dollar-based investments.
Fourth, there has been a growing concern among surplus nations – those countries that, because of their status as current account surplus countries that have built large amounts of foreign currency reserves, mostly Dollars – that the Dollar should be replaced as the world's major reserve currency. China, with over two trillion dollars in foreign currency reserves, most of it in Dollars, has been the leading proponent for such a shift, suggesting SDRs as an alternative. In the second quarter, only 37 percent of newly-acquired foreign exchange reserves, among developing nations, went into Dollar-denominated instruments, the lowest proportion in recent memory. There is almost no chance that the Dollar will lose its reserve-currency role within the foreseeable future but the trend seems to be moving inexorably against the Dollar. (This week India spent $6.7 billion to buy 200 tons of gold – a small portion of its total foreign currency reserves but a worrying development, for the Dollar, nevertheless.)
Fifth, lower interest rates in the US and the Dollar's attendant erosion saw the US currency replace the Japanese Yen as the currency of choice (for borrowing) in a new round of carry trades (investors borrow in the carry currency and invest in higher-yielding assets elsewhere). This has been a major factor behind the US currency's current weakness.
There were two other factors – less tangible – that contributed to the Dollar weakness as well. As the Dollar sank, loss of confidence in the ability of the currency to come back drove it even lower. And confidence was also eroding in the quality of US leadership. Barack Obama was elected with a clear mandate to effect change. In the first few months after taking office, his approval ratings were unprecedentedly high. However, as the months have passed, he has been able to accomplish very little. And, as he gets nothing done (beyond his rhetoric), he loses confidence among international investors. That too has contributed to the Dollar weakness.
Finally, there is a huge Dollar overhang in the world that, should inflation in the US began to increase or if there is any hint of an increase, those Dollars could come on the market.
In short, there has been little reason to buy Dollars.
The Future
That said, is there any hope for the Dollar? Was the anemic bounce in the last two weeks all we're going to see? Or, is it possible we can still see a sustained rally in the greenback?
Last week's rally was based on two factors. Growing signs of an economic recovery that is stronger than many investors have expected has led a number of those investors beginning to fear that central banks could move toward tighter monetary policy sooner rather than later. There are substantial fears among the central bankers that a rapid recovery could bring about increased inflation (although deflation is still a major worry). Should the banks act precipitously, investors fear the banks could choke off the nascent recovery. And that would prove disastrous for risky assets. Consequently, as economic numbers in the past two weeks proved to be more positive than expected (third quarter GDP grew at a better-than-expected 3.5-percent annualized pace; the Institute of Supply Management's October index came in at 55.7 – up from 52.6 in September, and above the 50-level signifying optimism), investors once more turned to the safe-haven Dollar.
Investors' fears turned out to have been ungrounded. In its credit meeting this week, the Fed once more opted to leave interest rates unchanged, again stating that it would leave the rates at their exceptionally low levels for an "extended period" – believed by Fed-watchers to be at least six months. (The Fed did spell out, however, which indicators it was watching regarding future rate decisions: low levels of rates of resource utilization, subdued inflation trends, and stable inflation expectations. Any aberrations in any of those indicators could lead the Fed to change its interest rate posture). Nevertheless, for the time being, rates will remain low, and the Dollar will remain a carry currency.
Friday's employment report further undermined the Dollar. Nonfarm payroll employment fell by 190,000 jobs in October, compared to an expected loss of 175,000 jobs (although the Labor Department also reported that August's and September's job losses were 91,000 less than originally reported), while the unemployment rate climbed to 10.2 percent, its highest level in 26 years.
What would lead to a Dollar rally? We see several scenarios. First, the Dollar is extremely oversold and a technical correction is overdue. Second, volatility in bonds has increased making it more expensive for investors to borrow the Dollars needed to short the Dollar. And third, a number of observers believe we are in the middle of an asset bubble. The rise in stock and commodity prices has not been justified by the fundamentals. A collapse (or even a major selloff) in these assets would drive the Dollar higher.
In summary, we do not foresee a collapse in the Dollar on the horizon. And we would not continue to sell the Dollar at these levels.
Comments for this post
Posts
