U.S. DOLLAR & GRAVITY'S PULL, THE

Futures, Apr 2008 by McMahon, Chris

The currency and forex sector offered great opportunities in 2007 as the dollar continued to decline and carry trades unwound. But a new set of assumptions is developing as the global and U.S. economies slow and U.S. interest rates drop.

The U.S. dollar has declined precipitously and except for a minor correction in 2005, consistently, since 2001. Its strength as measured by the U.S. dollar index, a basket of six major currencies developed in 1973, is at its weakest point ever after dropping to .7340 in early March.

The reasons are many: persistently low interest rates are probably the biggest cause, and the subprime lending crisis and resulting liquidity crunch have piled on. Now, lower consumer confidence resulting from evaporating home equity, softer employment numbers and a downturn in the business cycle, which prompted severe cuts in short-term interest rates, have taken the dollar to levels few even thought possible.

And the bad news keeps coming: the dollar dropped past $1.52 against the euro, crude oil is now trading at more than $100 per barrel, food prices are on the rise and The Institute for Supply Management manufacturing index declined in February to 48.3, indicating economic contraction.

That being the case, any serious talk about a dollar recovery is being deferred to the second part of the year.

"The ECB [European Central Bank] revised their GDP forecast down to just a few tenths of a percentage point higher than the Fed," says Kathy Lien, chief currency analyst for FXCM, indicating that growth in Europe also is slowing and that other central banks likely will eventually revise their forecasts down. "It has taken the focus away from yield and shifted their focus onto growth. And price action reflects the market's belief that the U.S. will see a shallow downturn and a quick recovery." But with futures markets already pricing in more cuts totaling 75 to 100 basis points, things will worsen for the U.S. dollar before they get better.

COMEBACK KID

In the case of a global economic slowdown, the United States could recover aggressively against the Euro zone, United Kingdom and Canada because it lowered rates sooner.

Prior to the ECB's March 6 meeting, the assumption was that the European economies would be slowing, which would lead to dovish rhetoric and an eventual rate cut. "That didn't happen," says Joe Trevisani, chief currency analyst for FX Solutions, and the U.S. dollar, which has fallen 13% against the euro in six months, will likely continue weakening because of the Fed's unwillingness to support it, even rhetorically. "When the Fed chairman says the obvious, that a weak dollar fosters U.S. exports, currency traders hear not a description of a currently weak dollar, but a prescription for a much weaker dollar in the future," he notes. And the ECB's continuing hawkishness, especially in the face of ongoing wage negotiations in Germany, likely pushed any U.S. dollar recovery out another two months, Trevisani says. "The ECB did not have to give up the anti inflationary rhetoric and they haven't done so."

Economic growth for individual countries will be the deciding factor, Lien says. Australia and New Zealand have been sheltered by the commodity boom and China's double digit GDP growth, as have the Euro zone, United Kingdom and Canada. But weaker economic data is starting to come out of those countries, and both Canada and the United Kingdom have recently lowered interest rates. In addition, the ECB has also revised its forecast down to 1.8% GDP growth for 2008, almost a full percentage point less than the 2007 growth rate. Lien expects the ECB to cut rates by 50 to 75 basis points later in the year.

When that happens, the countries that have lost the most at the expense of the euro will have the most to gain, says Rob Booker, independent forex trader. "There is a point at which Europe has to cry 'Uncle.' And when Europe cries 'Uncle,' they are going to have to catch up with the rest of the world," he adds. By May, he expects the dollar to trade between 146 and 147 against the euro. And he isn't the only dollar optimist.

Marilyn McDonald, analyst for Interbank FX, says that she expects the dollar to gain on the euro to 144. "At some point, traders will say, 'this is madness,'" and start to reverse.

Longer term, Andrew Wilkinson, analyst for Interactive Brokers, is slightly more optimistic and says the dollar will gain to 140 against the euro.

One way to gauge whether the U.S. economic recovery is proceeding is through the Treasury International Capital System (TICs data), a report from the U.S. Treasury that tracks money flowing into and out of the United States.

Booker explains that a proper recession in the United States could bring the equity bubble back down to earth and draw the interest of foreign firms, governments and investors. Those entities, rather than dumping down-trodden dollars, would more likely invest them in hard assets and buy more dollars to participate in the U.S. equities market.

Booker says that if the TICs data, which recently dropped to just above $50 billion, is not in the $70 billion to $100 billion range, it will indicate an insufficient demand for dollars and U.S. dollar denominated assets; and a sub $50 billion reading would indicate a more protracted recession.