U.S. DOLLAR: MISERY FINDS COMPANY

Futures, Sep 2008 by McMahon, Chris, Yu, Jason

While many analysts predict a recovery in the U.S. dollar, that expectation appears based more on a disbelief in how far the greenback has fallen than on fundamentals. But other currencies are now showing the same signs of stress and a change could be close.

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.

DAMAGED

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," right). 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%; Ql 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.