Dollar Bears on the Return?
One of the obvious consequences of the current and ongoing slowdown of the US economy on the back of the severe housing correction is that the Dollar bears are beginning to show their face again. Now, the bears' story is subtle but includes ingredients such as the before mentioned slowdown of the US and crucially a downward move by the Fed which would then finally make the US face the music of a whopping current account deficit and the need to correct this through the Dollar. In many ways the current US slowdown then will be a very interesting test case for the much debated issues of decoupling and global rebalancing. Now, let us begin with the triggering move which would be the declaration of intent by the Fed to actually approach the slowdown with a looser monetary stance or put it differently that any initial move against the Dollar would have to be guided by interest differentials between the Fed and the ECB and to some extent the BOJ. Of course, such a move by the Fed is not exactly looking realistic at this point moving forward with the recent inflation report showing inflation growth at a steady clip; The Skeptical Speculator and Dave Altig have the relevant points and figures.
Now, as I have argued before in my note The Anatomy of Global Re-balancing (and the follow-up here) there is a structural limit as to how far the Dollar can fall in a sudden abrupt rush in a world where China and the Petroexporters are still pegging. Indeed, my note linked above was written back in December where many commentators attatched volatility in the Eur/USD to the immiment beginning of the rebalancing and back then I noted the following;
The recent move in the Dollar in favor of the Euro has been driven by the expectations on narrowing interest differentials between the ECB and the Fed. Going into 2007 I do not predict this tendancy to persist primarily because I am not optimistic about growth prospects in the Eurozone. See also Credit Suisse's take here. Remember also that if you sincerely believe that the US economy will crash and subsequently are arguing as well that this will exacerbate the Dollar slide vs the Euro you are assuming a process of de-coupling. In short, the cause and effect analysis here limits the extent to which we can expect the Eurozone (and the ECB) to thunder along regardless of what happens in the rest of the world.
So, to the extent that I maintain my view could we could perhaps say that something has changed? Well, not a whole lot I think and this is exactly the point. However, one thing which caught my eye was the recent announcement in China of the creation of a new government agency to manage the huge (i.e. +1000 bn) and growing reserve portfolio which is accumulated on the back of the ever growing external surplus; Brad Setser also has much useful analysis and account on this. In essence, I think this has more to do with the need/intent for China to move into other asset classes in terms of the formal reserve management than it has to do with the Dollar per se but in any case. However, China still had, apparently, to reassure markets this Friday that this government agency would not have an effect on China's holdings on US denominated assets which is to say that the peg remains, so far at least. This brings me to me last point which is also echoed in my note linked above. The simple point I would like to make is that I do not see China or the Petroexporters for that matter diversifying to any sustainable degree into Euro or Yen donominated assets (debt) since this would cause an unacceptable appreciation of the Euro and the Yen in terms of economic fundamentals in the Eurozone and Japan. We could also operationalize this to say that there is a structural limit as to how far north the ECB and the BOJ can go relative to the Fed. Of course this theory is easily testable and as we venture further into 2007 we will see just how much longer the Boj and the ECB can push on. On very concrete thing to watch is the Eur/USD which recently rose to a three month high of 1.33 against the Dollar. So what I am saying here is merely ... watch that number climb to 1.35 or perhaps even 1.40; at some point we will have a breaking point as to how far the ECB will be able to venture along, that is my view at least.
In this brief note I have revived my arguments from December 2006 voiced in the note The Anatomy of Global Re-balancing (and the follow-up here) which takes on the claim of a fast and abrupt slide in the Dollar relative to the Euro on the back of first widening interest rate differentials and secondly a gradual but steady diversification process away from the Dollar among the big surplus nations' (i.e. the Dollar peggers) reserve managers. In reality, I think this all boils to the connection between the concepts of de-coupling and global re-balancing and how many commentators often tend to forget themselves. As such, the first important lesson I think is that any talk of a recession in the US at the same as a Dollar correction (i.e. the ultimate stagflation boggey man scenario) denotes the belief in decoupling by the Eurozone and Japan or the anticipation of the gradual float by China of the RMB as well as the Petro exporters' currencies. Consequently, there is a subtle yet crucial link between the re-balancing of the world growth and whether the rest of the world to minor of greater extent can (or perhaps will?) de-couple from the US economy.