Enter the Dollar Bears?
There is indeed much flurry about at the moment about the tumbling dollar and the slowing US economy. In fact this story has not gone untold on Alpha.Sources either (here, here, and here). Basically I am trying to hold back the tide here against the overwhelming amount of commentators who are arguing that now we finally have reached the time for re-balancing of the global macroeconomic imbalances. I am consequently not so sure (see also here and here) but wouldn't you believe it ... now also The Economist joins the club with the latest print edition in which the cover story (the leader) and a more in-depth article argue that the dollar will continue falling thus slowly but surely correcting the global imbalances; or put it another way, The Economist are structurally bearish on the dollar. So have I completely lost my mind here?
What I find most interesting about all this is not so much the discourse on the US economy. Indeed the US economy is slowing down mainly driven by a housing bust which has spilled over into consumer spending and confidence. This is quite naturally pushing the dollar down. And although the 3rd quarter GDP report was not as gory as expected the investors do not expect the Fed to raise any time before 2007 despite Bernanke's recent efforts to point to elevated inflation risks; see also Dave Altig's important point here. Furthermore, there is also no doubt that the large US current-account deficit is a factor here and indeed the dollar will need to fall to correct this, but herein lies also the problem in my opinion.
In order for the dollar to fall and the US current account to correct other currencies most be willing and indeed able to take on the dollar's depreciation. This is what this whole imbalances mess is all about and where the US indeed is slowing we should ask ourselves whether the fundamentals have changed in the Eurozone and Japan. In short; can the Euro and Yen carry the dollar depreciation on their backs?
This seems to be the main question here and I quite simply have to say no. However, the Economist is of another opinion at least on the Euro that is ...
There are two sides to any exchange rate: Europe's prospects matter as well as America's. In 2006 the euro area looks likely to grow at its fastest pace for six years. That its GDP growth is modest by American standards, largely because of its slower population growth, is not the point: what matters is that this year it has surprised the soothsayers time and again. That has lifted its currency, and not just against the dollar. A euro now buys more yen than at any time since the single currency was created.
This is indeed one way to look at it but we really need to take a long hard look at the Eurozone going into 2007 especially if the ECB is serious about normalizing rates at about 4.00% or perhaps even further north. And this is what this in my opinion is all about; interest differentials. Essentially we need to read the current situation in the Eurozone with a little more scrutiny. In essence what I think we are seeing is that investors and markets are postioning themselves for an invevitable raise from the ECB in December and perhaps also in the beginning of 2007 which brings us to an even more pertinent question, why would the ECB want to raise ... I mean inflation is running under the official target of 2%.
One thing here is the booming trend in corporate borrowing driven by low real interest rates and thus prompting the ECB to be cautious about excess liquidity. But another thing is that the ECB is caught in a damn tight spot mainly due to the recent gains in the Euro/Dollar. The point is that this has prompted finance ministers of Eurozone member and all other sorts of political and economic interests to poke their head out warning about how a rise in the Euro and rising rates could thwart the coming recovery. This ironically means that the ECB has to raise in order to show its independence from policy and this is consequently what we are going to see notwithstanding that the economic conditions do not merit an ECB heading north in an effort to normalize interest rates. In short, the Euro just simply cannot take on a structural correction at this point but the ECB is locked in towards at least one raise in december. What then for 2007?
Well, as I have argued before I am not at all optimistic about the Eurozone but it is clear that if the US falls into recession and the Fed goes out and cuts the rate the Euro will creep up once again. However, we are pretty much back to square one here; how will interest differentials be in 2007. My prediction ... I do not see the US economy falling into a nasty recession in 2007 as some indeed are arguing which is also why we should not expect the dollar to drift out over a cliff here, and why not you might ask? First of all because emerging markets, China, and the petroexporters (yep, go and see Brad Setser) have not yet signaled any serious attempt to diversify their reserves, that is to finance the US CA deficit. This of course will depend on the yields and if the Euro and Yen climbs up and the spread widens the exposure to a falling greenback might to harsh to cope with. So back to the interest differentials then; quite simply I believe there is a floor for just how far the dollar can fall. Let us first dispense with Japan here and I really would like to hear a serious argument in favor of a raising BOJ, especially with the recent in(de)flation data coming out of October. I am willing to bet a decent bottle of red wine that Japan will be back in ZIRP before the end of 2007. What about the ECB then? Well, I just do not see the ECB raising to any considerable extent in 2007, but of course we will see.