Washington leading the charge
May 4th 2008
The dollar rallies at last
HAS the dollar has turned against the euro and the yen? The American currency has at least bucked the downtrend (see chart). Having hit $1.60 against the euro on April 22nd, the greenback rose to $1.5379 on May 2nd. On that same date, the dollar hit ¥105.46.
This rebound owes much to the perception that the period of Federal Reserve easing may be coming to an end, a feeling that will be reinforced by Friday's better-than-expected non-farm payroll data. On April 30th, the Fed cut rates by a quarter of a point, rather than the half-point moves that had become the custom; its ambiguous statement left open the possibility that rates would be cut no further than 2%. Only a few weeks ago, investors were widely expecting a low of 1% or so.
Meanwhile, the economic data out of Europe, such as Belgian business confidence, has been fairly disappointing. Investors see the Fed as too proactive and the European Central Bank (ECB) as too sluggish. Growth prospects, rather than yield differentials, may be driving exchange rates at the moment.
Jim O'Neill, a strategist at Goldman Sachs, reckons that even if we have not seen the dollar bottom, we are close to it. He says the American trade data has been as encouraging as any he has seen in 27 years of looking at the markets, and the dollar is about as cheap as it has ever been in valuation terms.
Simon Derrick of the Bank of New York feels that mid-March may have been a turning point. He think it is significant that the euro has been responding less and less to the hawkish noises coming out of the ECB.
If the trend has turned, what does that mean for other assets? One of the biggest plays of the year so far has been to be short dollar, long commodities. Goldman Sachs calculates a 95% correlation between the oil price and the euro/dollar rate over the last year. Some of this is an accounting process. Since oil (and most other commodities) is priced in dollars, then a fall in the dollar should lead to a rise in prices. Goldman reckons that oil is driving the dollar, rather than the other way round.
The alternative view expressed by some commentators is that high commodity prices have resulted not from supply shortages but from the Fed's lax monetary policy, which is prompting investors to buy raw materials as an inflation hedge. The flaw in this theory is surely that gold, the most obvious haven for inflationphobes, has fallen quite sharply in recent weeks.
If Goldman is right, then commodities are moving for their own reasons and the dollar is caught in the slipstream. And thus one would expect a fall in the oil price to be good for the dollar. For a start, it would ease the pressure on America’s current-account deficit. It would also help American consumers: because of lower tax rates, the petrol price is unusually sensitive to changes in the level of crude.
For equity markets, the surprise this year has been that, in local-currency terms, Wall Street has outperformed Europe by nearly six percentage points (when the decline of the dollar against the euro is factored in, the effect is a wash). This may be down to the interest-rate cuts introduced by the Fed, but it may also be due to a lower dollar's effect on the overseas earnings of American companies, and the potential loss of competitiveness of their European rivals. This year, according to Dresdner Kleinwort, the market is forecasting 10.2% profits growth for American companies and just 2.2% for German firms.
A dollar rebound might help, in local-currency terms at least, the performance of the European equity markets. And in America, forecasts for the profits growth of multinationals might have to be revised down.
The effect on the bond markets of a rally in the dollar might be self-reinforcing. For years, there has been a nagging fear that, if the dollar falls too far, foreigners might lose their appetite for financing the current-account deficit, bond yields would be forced higher as a result.
But if the dollar rallies, that fear would be reduced, leading conceivably to more Treasury-bond purchases, boosting the dollar's rebound. After all, investors in eurozone government bonds lose less than a percentage point in yield by switching to Treasuries—and the euro/dollar rate can easily move by 1% in a day. And, of course, if a rising dollar were also accompanied by falling commodity prices, that would be good news for Treasury bonds.