- Worry becomes electric in the United States
- ECB, FED and BOE rate divergence?
- The dollar bides its time
Is the long rumored US slowdown is about to become real and verified by statistics? Do we have a case of sell the rumor and buy the fact for the US dollar?
The Dow fell 4.2% in three trading days this week; the dollar lost only a little more than 1% against the euro during the same period. There is little direct day to day correlation between trading in the New York equities averages and the currency market valuation of the US dollar. But this week's Dow collapse was prompted by two dismal US statistics, a sub 50 ISM Manufacturing Index and a very weak Non Farm Payrolls report. Both seem to presage a much slower if not recessionary American economy. The reaction of equities traders was one of disappointed hope, but no so the dollar traders.
Has the currency market evaluation of US economic prospects been so negative that the arrival of the slowdown becomes the occasion for a classic reversal? To put it another way, has the 'recession' already been priced into the currency markets and if it is now hereâ€”not yet a fact despite the statisticsâ€”has the dollar no where to go but up? Questions looking for answers, truly, and one should be careful of making too much of a short term move but the blasÃ© reaction of currency traders to these dismal and unexpected numbers requires explanation.
There is little doubt that an American economic slowdown has long been the operating assumption for the currency markets; it is has been one of the drivers for the ascent of the euro since August. But the logic for a dollar recovery is straightforward. If an American economic slowdown or a recession is priced into the current dollar level, as I believe it is, then the questions become, what happens to the dollar if the US enters recession, what happens if it doesn't and where does the dollar go when the issue is decided? There is an objective definition of recession, two successive quarters of shrinking GDP, but since traders must operate with imperfect foresight we can use weakening US statistics in lieu of the formal definition. Will more statistics like the ISM and NFP results drag the dollar down?
Let us examine the possibilities.
If the United States is headed for or perhaps has already entered a recession can the Eurozone be far behind? If the Fed and the BOE are reducing rates can the ECB afford to be the market's sole anti inflation paladin? Judging by the reaction of the currency markets the answer is no. If traders really believed that the ECB would hold the line on rates indefinitely then the recent US numbers, clearly indicative of further Fed rate cuts and a widening gap in base rates for the two currencies, should have driven the US lower. They did not. My view is that US economic weakness and further Fed cuts were anticipated and already factored into the dollar level. The assumption that the US economy will falter may well have as its unstated corollary that where the US leads the Eurozone will soon follow.
And if the US does enter recession what then? The dollar may weaken marginally as the few remaining economic optimists are converted but very soon the focus will shift to the second half of this year. As the fall in the dollar from August to the end of the year anticipated, for arguments sake, a recession in the first quarters of 2008, so a dollar recovery, in early 2008 could anticipate a US economic resurgence in the last quarters of the year.
At the end of the first quarter it will be six months from the first Fed cut on September 18th. . That is when traders will expect the Fed stimulus to begin its work. It is also when the ECB lack of attention will begin to bite. Despite the ominous tone of much press coverage of the housing and financial sectors, the conditions which have been threatening to derail consumer spending and business activity will not last forever. The housing collapse has been gathering steam for two years; the asset backed mess will be more than six months old at the end of the first quarter. If for no other reason than short market attention spans and traders' perennial focus on what is over the horizon both crises will be much diminished as sources for dollar weakness by the end of the first quarter.
If on the other hand the US economy does not enter recession, if Non Farm payrolls are revised much higher, as then have been in the past, if consumer spending does not crack, and the economy does not slow to sub 1% GDP growth then the dollar has no place to go but up. Current dollar levels are predicated on serious weakness in the US economy. No economic weakness, no falling dollar.
Either way the economy goes the dollar looks primed for recovery. The dollar is at current levels because it has been struggling under the assumption of a recession. If the recession is here, then it is out of the way and the market will move to the next target. If the recession does not materialize, then the market has been wrong and traders will have to buy back their short dollar positions. Either way the dollar rises. If a US economic slowdown or recession has been priced into the market, then logic dictates the dollar must shortly begin to gain, regardless of whether the recession is or ever will be, real.
Cyprus and Malta joined the European Monetary Union, as of January 1st, becoming the 14th and 15th European Union member nations to give up their national currencies and join the Euro. The Cyprus Pound and the Maltese Lira will soon disappear from circulation, remembered only by historians. 15 out of 27 EU members now belong to the European Monetary Union and use the euro.
Athanasios Orphanides governor of the Cypriot Central Bank said that the ECB stands ready to raise rates if needed. But his comments, much as recent comments by Jurgen Stark and others, must be taken with certain skepticism. With European economic growth set, by the bank's own projections, to slow to 2% or less, with the euro close to its all time high against the dollar, with the credit and financial turmoil still unwinding and with a US recession becoming more likely, the chance of an ECB rate hike is negligible. A central bank has two major tools to manipulate markets, interest rates and rhetoric. Sometimes rhetoric is a creditable guide to future action, but in this case, the rhetoric is mere words. The ECB will not change its rate policy on Thursday.
ISM and NFP have weighed in and futures pricing makes a 25 basis point cut at the January 30th meeting a near certainty. Speculation that the Fed will cut 50 points or be forced to make an interim reduction before the FOMC meeting now is now heavily entertained.
FOMC minutes of the December meeting where the Fed funds rate was cut by 25 basis points reflected a committee unanimous only in its uncertainty. With economic indicators pointing in several directions and with plenty of overhanging if not yet substantive worry in the financial markets, the housing sector and on consumer spending, the varied opinions of the board members mirrored the lack of consensus in the statistics and in the markets generally. But the minutes also depicted a board more concerned about the state of the economy than the rate of inflation. Or to quote form the minutes themselves, some govenors anticipate the need for substantial further easing of policy. With that mindset on the board and the weak ISM and NFP numbers, expectations for a rate cut at the end of January will not diminish a whit no matter the intervening statistics.
Bank of England
Market opinion is evenly balanced between a 25 basis point cut and a continued hold at the Monetary Policy Committee (MPC) meeting this Thursday. Though last month's cut surprised the market and inflation is a major concern, it is possible that the MPC members will wait for the February 13th quarterly inflation report before making their decision. The recent softness in manufacturing and purchasing indices are not thought to be weak enough to force the MPC's hand and they were balanced by a stronger than anticipated PMI services report.
United Arab Emirates
The central bank of the United Arab Emirates, the source of much capital recently for western financial corporations, has decided, after review, to retain their currency peg to the US Dollar. Given the damage that removal of the peg would have done to their own dollar reserves, the decision was not unexpected. However, in the current weak dollar environment the review had generated a good deal of speculation about the negative consequences for the dollar if the peg had been converted to euro or to a basket of currencies. That worry is now removed.