Tuesday, February 08, 2005

On the Dollar

Much has been written about the twin deficits, trade and budget, and how they will bring the dollar to ruin. Quietly, though certainly not beneath the notice of market professionals, the dollar has rallied strongly since the new year, particularly against the euro and the swiss franc. The dollar has rallied from 1.3650 to 1.2750 against the euro (note, eur/usd is quoted "dollars per euro" = a falling rate means a rising dollar) and has risen from 1.14 to 1.22 against the swiss franc (usd/chf is quoted "franc per dollar"). The dollar rally has calmed panicky Europeans who I believe were not far from at least making a symbolic show of currency intervention. (which would not have been effective since the Treasury would not have joined)

What has changed? The spectre of nominally large (though manageable when compared with GDP) trade and budget deficits remain. However, a leading investment bank notes that equity flows to the US have ramped up in the past couple months and the strength looks to continue. [These foreign inflows - on a significantly larger scale - have propelled the late 90s technology boom]. Also a big part of the euro rally last year were central banks rebalancing reserves. 'Rebalance' is a bit of a euphemism as it means scores of billions done over time. I think the central banks are done for the moment.

US short term rates are rising and will continue this year until the fed funds rate hits 4.0%. Since world rates are generally stable this means that the differential between US rates and world rates are increasing making it more expensive to be short the dollar. (Note, most speculators will borrow dollars to sell to be long euros and have to pay this interest rate differential.)

Finally, there is sentiment and market position. Globally sentiment has been dollar negative for some time. The US twin deficits are a big part of that but general anti-US sentiment over the past two years has certainly played a major role. Speculators as well as managed money have been aggressively short US dollars. This strategy paid off handsomely last year. However, those winning positions have been losers so far this year. It is early yet in 2005 but continued dollar strength will surprise and bring pain to speculators and investors. If speculators get 'stopped out' of their positions - and real money re-deploys to keep pace with their benchmarks we could see an aggressive dollar rally. Here's a clue, last Friday's non-farm payrolls numbers - by FAR the most important data of the month - came out weak at 140k new jobs vs expectations of 200-250k and the dollar RALLIED. (The unemployment rate did fall to 5.2% but the market generally watches the payrolls number more closely)

I rather think we are closer to the bottom than the top in the dollar. There'll be headwinds for sure but I think contined dollar weakness is no longer a foregone conclusion.

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