Buy US Dollars - Even the strongest rally doesn’t move in a strai
Foreign Exchange Outlook : We get some US data today, including the ISM service sector index for Dec (probably a decline to 36.5), existing home contracts, factory orders, and the minutes of the Fed Dec 16 meeting. The Fed minutes will be interesting because they will disclose the reasoning behind taking rates to a range of zero to 25%. Today is also probably the day that Friday’s payrolls come onto the radar screen.
Still, the overriding factor is the ECB rate cut now universally expected next week and the associated rhetoric as well as the amount (25 bp or 50 bp) and the pace of future cuts. Bloomberg reports that ECB policy member Constancio said yesterday (before today’s inflation numbers) that the bank is prepared to cut interest rates if necessary to keep inflation on target. If price growth slows below the goal of "just below 2%," the bank will respond with rate cuts. This is nothing more than confirmation of what we already know, but central banks have their own intricate dance with the market and it's necessary for the bank to disclose its intentions out loud. We can’t wait to hear from the BBK's Weber. As for the extent of cuts, Bloomberg says its survey shows ECB rates down from 2.5% to 1.5% by end-June, or a total of 100 bp in cuts. We think the market may reward the euro exchange rate with a bump up if the first move is a biggie, at least 50 bp.
Also, we need to look at two intermarket factors, the rise in US 10-year note yields and the price of oil. We are seeing a rise in yields and steepening of the yield curve in part on hope that the Obama team can drive recovery. As a general rule, this is US dollar rate - favorable. But not to the mind of former Bank of England policy committee member Buiter, who says Americans must prepare themselves for a "massive collapse" in the dollar as investors around the world dump US assets, according to a piece in the Telegraph newspaper. This is a tabloid newspaper that loves shocking headlines, although Buiter is a reputable source. Buiter says there will be increasing disenchantment with the US economy and thus an exodus of foreigners.
Well, probably not. Recently both the Japanese and Chinese have affirmed that they will continue to buy US government paper for reserves, even though China has already said Q4 reserves will show a drop because of the dollar's decline late last year. Some forex analysts say this is no big deal - these reserve managers have a distinct lack of other good assets to choose from. Even European bonds are not a real alternative to US paper since the European bond market is made up of individual country paper and some of it is getting the benefit of the doubt from the existence of the euro exchange rates and not because of good underlying fundamentals (like Italy). We are inclined to accept the no-good-alternative argument. If Buiter were right and the dollar exchange rate gets dumped as the Treasury holds auctions and nobody comes, the global financial system would face a bigger Shock than anything we have seen so far. We may not like it, but as goes the US economy and the US government bond market, so goes the rest of the world.
Oil is a more immediate and pressing problem. We complained all last year that the inverse correlation of the dollar and oil was silly (beset by circular reasoning whereby oil traders said they were buying oil as a speculative asset because the dollar was falling and currency traders said the dollar was falling because oil was rising). This correlation is not a necessary one—we have had periods when the dollar and oil moved the same way and not inversely. But the speculative psychology could easily come back and give us wildly higher oil prices, and perhaps a wildly lower dollar, on very little evidence. We still want to see greater regulation of the oil market in some way - when oil is treated as a financial asset and not a commodity, it becomes less linked to valid supply and demand determinants and takes on the irrationality of financial markets. Oil is too important to be controlled by greedy, nasty yuppies at Goldman Sachs. But critics are right that regulating this market may cause more trouble than it cures. Who exactly would be qualified to do it, and how? Net-net, we see oil as the biggest threat to the dollar rally, not US economic fundamentals (and we are not certain that the Obama rescue plans will work in the first place).
Finally, today is Tuesday and we often get a pullback on Tuesdays, or so market lore has it. Even the strongest rally doesn’t move in a straight line. But keep the faith - it’s a true new trend and unless something comes along to derail it, we have more time to enjoy it.
Bye For Now