Currencies
What It Would Take for the Dollar to Recover
By Marc Chandler
Street.com Contributor
7/20/2007 1:00 PM EDT
Clearly any recovery in the dollar is dependent on someone buying the dollar. It may be a worthwhile exercise to consider who would buy the dollar.
Using the Chicago Mercantile Exchange's International Monetary Market Commitment of Traders report and anecdotal and proprietary data, among short-term players, speculators have amassed a large short dollar position. The net short U.S. dollar positions in the futures market stand near record highs. The trade is crowded and in such market conditions, it does not take much to spark a short-squeeze.
Central banks continue to buy U.S. dollars, a fact that has largely been lost in all the talk of reserve diversification and the establishment of sovereign wealth funds.
The Federal Reserve's custody holdings data, which offer information not necessarily contained in the TIC data (the TIC report picks up activity only through the U.S. banking system), showed a $6.5 billion increase in the latest week of Treasury and Agencies for foreign official accounts. Since the fourth week in June, the Fed's custody holdings have risen by about $40 billion and year to date almost $250 billion (well more than the U.S. budget deficit this year, for example).
Americans themselves have been selling dollars to invest in foreign equity markets. If they stopped chasing yesterdays' returns and began buying U.S. shares, that might also reduce a pressure on the greenback.
One week does not make a trend for sure, but weekly U.S. equity flows may be worth monitoring a bit more closely. TrimTabs reports in the latest week that mutual funds and ETFs that invest in the U.S. took in $5.3 billion after a combined inflow of less than $800 million the previous two weeks. Mutual funds and ETFs that invest outside the U.S., however, took in $7.4 billion, compared with about $7.5 billion in the previous two weeks.
The focus on who could be a dollar buyer also involves asking why they would be a dollar buyer. Leaving aside the central banks, whose reserve accumulation this year already surpasses the net new sovereign issuance from the U.S. and Europe for the entire year, what would prompt investors to buy dollars?
Even though, as they say, past performance is no indication of future returns, it may be helpful to review the recent price action. Like a cascading effect, the Australian dollar, sterling and euro put in their spring peaks against the dollar between mid- and late April. The dollar recovered for several weeks. The Australian dollar bottomed in late May, sterling in early June and the euro in mid-June.
Consider the macroeconomic context for that price action. First, the weak economic performance in the first quarter prompted the market to price in not one but several interest rate cuts by the Federal Reserve. Recession talk intensified to frenzy levels.
Then, as early second-quarter data began coming in, it became clear that rather than continuing to slump, the U.S. economy was rebounding smartly. That appreciation, coupled with the Fed's insistence that the upside risks to inflation were greater than the downside risks to growth, underpinned what could have been a simply technical correction.
For a few days in mid-June the market actually priced in a small chance that the Federal Reserve would hike rates before year-end. However, that view was quickly reversed, as was the dollar, when Bear Stearns' (BSC) hedge fund problems came to light.
And that was that, as further news of continued contraction in housing, the rising delinquency rates and falling prices sparked new anxiety over the general credit conditions.
Although comments from Fed officials, including Chairman Ben Bernanke's testimony this week and the FOMC minutes from last month's meeting, seem to point to Fed policy being decisively on hold, the market continues to discount the chance of a cut. That chance was as small as about 1 in 10 after the stronger-than-expected U.S. June jobs report, but it has since risen to almost a 30% chance (using the December fed funds futures contract).
If the U.S. dollar is going to recover, it seems that the market needs to abandon its predilection for believing that the Fed wants to cut interest rates. Since the Fed stopped hiking rates in June 2006, the market has consistently, with the noted exception above, assumed that the next move is a cut.
Interestingly, in the middle of the second quarter, several large investment banks did in fact revise their Fed forecasts and no longer looked for multiple cuts. Some gave up on a cut entirely this year; others reduced their view to a single cut late in the year. It is telling that core measures of inflation had begun slipping as the Fed's view shifted.
This is important, because it suggests that it is growth, not inflation, that is the key to Fed expectations. In terms of the budget deficit, U.S. President Ronald Reagan, President Bill Clinton and now President George W. Bush have demonstrated the ability to grow out of the fiscal straits. Economic growth may provide a panacea or make it easier to absorb the dislocation caused by the subprime/housing market problems.
Next week, on July 27, the U.S. will report its first estimate of second-quarter GDP. The Bloomberg consensus calls for a 3.2% annual growth pace. Even though this is consistent with a stark improvement from the 0.7% pace of the first quarter, the risk is on the upside.
Inventories and trade probably swung from around a 1 percentage point of drag on growth to a net positive contribution. Residential construction remains a drag, but it looks to have been reduced. The consumer pulled back after a shopping spree in recent quarters, but foreign demand, non-residential construction and business investment picked up the slack.
However, the dollar probably needs evidence that the pickup activity in the second quarter was not just payback for the soft first quarter and that the economy enjoys good momentum in the third quarter. This is consistent with the Federal Reserve's central tendency forecast.
Of course, the general credit conditions do matter. There has been some repricing of risk and widening of some credit spreads, but by all comparisons but the most recent period, spreads are still relatively tight.
If growth and the evolution of expectations of Fed policy trajectory are key to the dollar, maybe the equity performance of the financial sector offers a shorthand to wading through the morass and alphabet soup of mortgage-backed securities and derivatives. The health of the financial system may be the key to weathering the potential storm.
At time of publication, Chandler had no position in the stock mentioned in this column.
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