A Federal Reserve hint, a Non Farm Payrolls less damming than feared, a contracting but not deteriorating manufacturing ISM and a barely expansionary GDP were the US ingredients for a major dollar rally this week. In isolation there is little in these numbers to cheer, but in context each allayed a particular worry for the American economy.
From Monday’s open to Friday’s close the dollar gained 1.34% against the European currency. In the past two weeks the dollar has appreciated 2.66% on the euro. That is the best two week performance for the US currency since the beginning of the credit crisis last August. The precipitous dollar decline that began last summer had erased almost 20% of its value against the euro. This week’s return may turn out to be transitory if the US economy slips further into decline. But much as the rally in the US equities envisages economic recovery so the dollar reversal is poised to continue as long there is no substantial deterioration in US statistics; it will not yet be necessary for US statistics to show marked improvement for the dollar to retain its upward trajectory.
Since the credit and liquidity crisis began last August the fear stalking the markets has been of an ever intensifying financial and economic debacle in the United States. Remove that fear and relief may well carry the markets until the Fed rate cuts begin to work in earnest later in the year.
But it was not only the lack of worsening American statistics that propelled the dollar higher.
It was a thin week for European statistics with the Labor Day holiday mid–week (once called May Day) curtailing market activity. Those statistics that were available reflected diminishing expectations for European economic growth and slightly lower inflation. Neither supported the euro. All components of the European Monetary Union (EMU) Economic Sentiment Index fell except consumer confidence which was already at a two year low. The preliminary April EMU Manufacturing Purchasing Managers Index (PMI) was the weakest since August 2005. The harmonized inflation index for April shed 0.3% to 3.3%. It is still well over the 2.0% ECB target rate, but having seen off the March peak of 3.6% it may offer ECB rate hawks some cover in their rhetorical campaign against inflation.
Germany reported lower harmonized annual inflation (preliminary) in April of 2.6%, a notable reduction from the 3.3% reading in March. The final manufacturing PMI number for April sank to 53.6 from 55.1 in March. And in what has become the standard result, retail sales as reported by the Federal Statistical Office, were 6.3% lower in March than a year ago. There is little outright gloom on the continent, but there is precious little cheer.
None of these statistics, on either side of the Atlantic, are more than the first reading of a script that has been in development since the Fed began cutting rates last September. When traders combined the American and European statistics with the FOMC statement on Wednesday that referred to the substantial easing of rates that had already taken place, even as the committee cut rates a further 0.25%, the end of the Fed reduction cycle suddenly seemed a lot closer than it had been the day before.
It normally takes from six to twelve months before a program of Federal Reserve rate decreases begins to have a positive effect on the US economy. We are almost midway through that period, if dated from the first cut last September and there has been no discernable economic response.
But we should be careful to date the beginning of the expected effect only from that first FOMC rate cut of 75 bps last September 18th. The Fed has reduced the Fed Funds target rate 3.25% in a series of moves that stretches almost eight months from mid September last year to this past Wednesday.
If we make the assumption that the Fed began a rate pause on Wednesday, half of the total eight month rate cutting period brings us to mid January this year. If we begin look for an economic response six months to twelve months from mid January instead of from last September then nothing might be expected to show up in US statistics before July.
Can the recent economic stall, or the hiatus in the rate of decline, that we have seen in a number of important US statistics over the past few weeks be attributed to the Fed interventions. Possibly. But there are still considerable dangers for the American economy. The housing market has not found a bottom. Though the pace of the fall has slackened somewhat, there are still more price drops to come until the large supply of new and existing homes reaches market clearing price levels. And there are lingering concerns related to the credit crisis that are still tightening credit and probably consumer spending.
But no one should expect the US economy to return to health in one swift bound. Considering the extraordinary events of the past nine months and the yet to be surmounted housing bust, a period of moribund growth is most likely. Since we can logically delay looking for the beginning of a Fed inspired economic recovery until mid to late summer, the trader inclination to ad-lib the dollar recovery before the script is completed is a perfectly good reading.