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U.S. Dollar: Misery Finds Company

Note: This feature length cover story by Chris McMahon originally appeared in the September 2008 issue of Futures Magazine.
Link to original @ Futures Magazine

USD: Misery Finds Company
The Federal Reserve Bank cut 325 basis points from the Fed funds rate from September 2007 through April of this year in an effort to stimulate our flagging economy and to shore up the banking industry in the face of subprime related fallout. The effort may have staved off full blown recession, however it has accelerated inflation and undercut the value of the world's reserve currency. The outgoing administration of George W. Bush has spent nearly two full terms in a state of denial regarding the weakening U.S. dollar. The U.S. dollar index has declined from a high of 1.2190 in 2001 to trade consistently below 0.7500 for most of this year. Now there is growing concern that sovereign governments, ever more squeamish about the erosion of their massive dollar holdings, could lighten their positions further if steps aren't taken to bolster the greenback.

In May, net foreign purchases of long-term U.S. securities were $67 billion, down from $111.9 billion in April, indicating that non-U.S. buyers are losing their appetite for U.S. dollar denominated securities. Overall, the U.S. dollar accounts for about two-thirds of global reserves, down from three-quarters, and the euro has increased to about one-third, up from about a quarter.

"You can make a case that the wreck is coming," says Joseph Trevisani, chief market analyst for FX Solutions. "But people have been making that case for a year now. The one thing we have seen over the past two years has been the dollar's continued refusal to collapse." Despite the end of the business cycle, he doesn't see any of the classic signs of recession: rapidly increasing unemployment and sharply lower manufacturing and business spending.

As bleak as the U.S. economic situation appears, there are dollar bulls out there. Currency trader Rob Booker has been long the U.S. dollar for months. "I haven't been correct," he laughs, but he still believes three things: Having benefited the most from five years of expansion, the euro stands to lose the most from the global slowdown; the bad news is already priced into the dollar; and in the sluggish world economy, demand for expensive European goods and assets will fall while demand for discounted U.S. goods and assets will increase.

"A lot of the major negatives are in the process of reversing," says Brian Dolan, chief currency strategist at Gain Capital. Over the next quarter, he expects a dollar recovery, albeit minor. For those traveling abroad, the anemic dollar has been a major eye opener, laments Kim A. Rupert, managing director of global fixed income analysis for Action Economics. "Fundamentals indicate that the dollar will weaken, but not substantially and not at an accelerated pace." But Kathy Lien, director of currency research at Global Forex Trading, says the problems confronting the dollar are fourfold: the labor, housing and financial markets and inflation. "And three of these factors are getting worse," she says.


The U.S. labor market continues to do poorly, with the unemployment rate climbing in July to 5.7%, up from 5.5% in June, and the news is full of high profile layoffs, including Wachovia: 6,000 layoffs; United Airlines: 7,000 layoffs; and accumulating layoffs and buyouts at General Motors and Ford. But given that the most recent expansion added fewer jobs than typical, the conventional wisdom is that on a relative basis, job losses will be fewer than in previous downturns.

"In past recessions, we have seen a minimum of 11 months of drops in nonfarm payrolls. Since January, we have had seven, so I am looking for job losses to continue into next year," Lien says (see "Layoffs mount"). Those job losses likely will manifest in decreased consumer spending, which accounts for 70% of the U.S. economy. Consumer spending declined 0.2% in June and high food and oil prices remain a threat. "Last month, [June] if you strip out the gasoline component, retail sales dropped 0.5% rather than rising 0.1% or 0.2%," she observes.

Trevisani acknowledges that the labor market has been weaker, but says reductions in the Fed funds rate are still working through the economy and that the weak dollar continues to benefit exporters.

While the United States has so far averted two consecutive quarters of negative growth as defined by gross domestic product, the slowdown is real. GDP for the fourth quarter of 2007 was revised to -0.2%; Q1 2008 GDP was revised down to 0.9%, and Q2 GDP came in at 1.9%, short of the consensus expectation of 2.2%. Trevisani postulates that because of the rapid evolution of the U.S. economy, some portion of business activity is not being captured in business statistics and earnings. "However stretched the consumer may be, the stimulus checks were largely spent and not saved or used to pay down debt," he says, noting that in early August the dollar was trading at 1.5450, its six-week high against the euro.

In June, the Consumer Price Index was 5% higher year over year, well beyond the Federal Reserve's well publicized 2% comfort zone and an indication that rising transportation and materials costs are now being handed on to consumers.

Rising inflationary concerns have already caused some industries to hold back on planned capital expenditures, and Rupert says inflation and slowing growth likely will continue through the rest of the year and into 2009. "We have seen the 10-year yield go from about 380 [basis points] to about 410 since that CPI was announced. That's a flight out of 10-year notes," she says, explaining that inflation affects long-dated Treasuries more than short dated, so we have seen selling of longer-dated Treasuries. But, should the Fed then start hiking rates, a full blown recession could descend in early to mid 2009. "The expansion is long in the tooth. Once the Fed starts to hike rates, and these inflation expectations start to cause some major industries to scale back, that will have a more deleterious affect on the economy than the housing crunch did over the last couple years."

As second quarter earnings started to come in, there was hope that the housing and financial markets would find a bottom as U.S. banks were raising capital, writing off risky assets and finding some buyers for their discounted stocks.

"Second quarter bank earnings will be a watershed moment," Dolan says, adding that the U.S. outlook will be subdued until the housing market recovers, but short term, he says the downturn won't be as severe as predicted. "They're getting their house in order. Merrill Lynch cut their level 3 assets to $2.5 billion. Even if they have to write that off, it's less than previous quarters," Dolan says. Allowing that the sector will take several quarters to repair, he noted the boost it enjoyed in the third week of July after legislation was passed to eliminate short selling of government sponsored enterprises (GSE), including Fannie Mae and Freddie Mac.

But the bad news was persistent. In late July, Treasury Secretary Hank Paulson said more bank failures were on the way (see "Hold 'em"); and just days later, Fannie

Mae and Freddie Mac dropped 20% in a single day and Washington Mutual shed 13% of its value.

"That's just one more sign of the subprime mess and resulting credit problems that have caused banks and institutions to write down more than $400 billion in loses; still a drop in the bucket relative to a $12 trillion economy, but it's bad news for the industries affected, namely the financial institutions," Rupert says, adding that tighter borrowing requirements have impacted the economy and will slow the recovery.

Singling out American Express and Wachovia for significantly missing analysts' expectations, Lien says bank earnings are disappointing and likely persistent. "The troubles with Fannie [Mae] and Freddie [Mac] are not behind us. To some degree, the financial markets have stabilized, but what you are seeing is a lot of risk aversion in the markets, which is why things like gold prices have been doing well. That's why credit spreads are still at lofty levels."

But Booker sees the stream of bad U.S. economic news as an indication of transparency. "A lot of the panic and madness has already been priced into the dollar," he says, and the likelihood of an unforeseen bank failure or write down is more likely in the European Union than in the United States. "We haven't priced in any negative news about Europe. Europe is just floating along. Europe is now the poster child for economic stability? Four of the countries don't even want to be part of the European Economic Community anymore!"


The strength of the dollar depends greatly on the Federal Reserve Bank's monetary policy, but perhaps more than ever, the relative strength of the greenback depends on non-U.S. central banks and the convergence or divergence of interest rates, especially in the European Union.

Economic difficulties in Portugal, Italy, Greece and Spain are offsetting growth in Germany and France and dragging down the Euro zone's growth, while the annual inflation rate hit 4% through June.

In addition, European Central Bank President Jean-Claude Trichet has maintained an extremely hawkish attitude towards European inflation, even as growth has slowed, raising short-term rates to 4.25% in July, which put more pressure on the dollar.

"Trichet has essentially bet the world that the European economy can take a beating with simultaneous slow growth and rising inflation," Booker says. "He's wrong. Europe is not immune to the problems we have seen," he says.

In the United Kingdom, unemployment claims recently hit their highest level since the 1990s. "They are dealing with the same problems the U.S. is dealing with, just a few months behind us," Lien says. "Misery has found company, and that's why the decline of the dollar has slowed," she says. "There are no new factors that will take us out of this range against the euro, the British pound and the Japanese yen."


Dolan says the Fed gave itself a little bit of insurance with previous cuts and says it will take back 25 basis points before the end of the year. "Given the state of the economy, 25 or even 50 basis points would not be devastating. It could also be seen as a vote of confidence in the outlook that the U.S. is in the process of bottoming out and recovering. They cannot continue to foam at the mouth about inflation without taking some action, or their credibility tanks." During the third quarter, Dolan expects the euro to fall to between 1.45 and 1.50 against the dollar, and for the dollar to trade between 1.13 and 1.16 against the yen.

Lien expects no cuts to the Fed funds rate for the rest of the year. "The eurodollar will probably remain in the 1.56 to 1.60 range," she says. Against the British pound, she expects it to remain below 2.0175, the high from July, and above 1.97. The yen will trade between 1.04 and 1.08.

"Most assume the Fed won't act on policy prior to the elections, so the first opportunity the Fed will have to raise rates is at the FOMC meeting on Dec. 16," Rupert says. "Fed speakers will remain hawkish going into that time to prevent inflation expectations from becoming unanchored, but they will just talk tough."

Booker says his three month target against the euro is $1.50. He expects the dollar to fall to 1.01 against the yen, given that they are isolated from most of the world's financial risks. Trevisani's target is 1.52 against the euro and 1.08 against the yen.

Should the United States' economic deterioration ebb, traders will increasingly ask when the dollar recovery begins and how long it will take. And for those with the guts, stamina and available margin, the opportunity could astound.

"We have been presented with the greatest discounting of the U.S. financial system, including the dollar, of all time. And while the rest of the world is panicking, what are you doing?" Booker asks. "Do you want to be the last guy to sell the U.S. dollar? The time to do that was five years ago."

Note: This feature length cover story by Chris McMahon originally appeared in the September 2008 issue of Futures Magazine.

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