Feeling Dollar-Bearish?

Quotable

“Without rules and supervision, the world runs the risk of being condemned to increasingly serious and severe crises.”
                                          Nicolas Sarkozy

Commentary & Analysis
Feeling Dollar-Bearish?

The euro appears contained today. But what’s new? The upcoming jobs report is the reason the euro isn’t climbing again, even though next week the European Central Bank is highly expected to move interest rates up by 25 basis points. Until then, any developments (like unsustainably high yields in Portugal) related to the Eurozone’s periphery countries – positive or negative – likely will not threaten the euro’s rise. If the ECB opts not to hike rates, however, and especially if they don’t sound very hawkish, then the euro will probably fall of a cliff (at least in the short-term.)

So since finding reasons to be euro-bearish have been useless recently, maybe it makes more sense to find reasons to be dollar-bearish. Here are two soon-to-be-determined events where we should look for clues:

GDP Flops or Payrolls Disappoint

US stock markets and analyst expectations have been expecting a steadily improving trend in the US labor market. Indeed the private sector has been pretty good about adding jobs as of late. There are of course some key concerns keeping employers tentative on this front, but no one really expects the situation could worsen. If for some reason non-farm payrolls surprise to the downside with today’s report, the market implications could be severe.

But already a more tangible worry is the potential for downward GDP revisions based on a slump in economic activity. Yes, surveys and indicators have been leaving many analysts feeling rosy about a US recovery, but there are some who point to a big disappointment as a real reason for caution: durable goods.

When durable goods were reported at -0.9% last week versus expectations for +1.2%, it added to the month earlier report of a whopping -6% drop in orders. Currently, consensus expectations for US GDP are around 3.5% or so. It is suggested durable goods could contribute to something near a 2.5% number for GDP.

That’s a pretty sharp difference. And based on our expectations that the US dollar’s best chance at appreciation is via an advantage on the growth front and, subsequently, an improvement in expected yield differential for the dollar, a GDP disappointment would likely hurt. [Disclaimer: this dollar outlook would obviously change if the weaker US GDP figure sparked a substantial wave of risk-aversion, sending money flooding out of stocks and commodities in search of safety in US dollars.]

QE2 Ends

The Fed’s second round of quantitative easing is due to expire in June. As of now there are no hints from the Fed that they will need to adopt QE3. This likely means that asset markets have one last drink (in the seoncd quarter) before the Fed take the punch bowl away (at least temporarily.) After that, these asset markets could probably take a serious nap unless there are clear signs that the Fed is not needed to support economic growth.

If asset markets do take a nap starting in July, and growth expectations sour, then the Fed will likely bring back the punchbowl. In such a situation, the US dollar continues its downward push until investors become fearful that supporting evidence to hold stocks, commodities, etc. has vanished. And assuming no major change in interest rate policy, the rug will again be pulled out from under the dollar when the punchbowl returns. Party time is here again!

This of course assumes the Fed doesn’t step in with QE3 within a few days of QE being laid to rest. An almost immediate QE3 would mean the Fed still takes issue with some things

WILD CARD: Gee, 20 meet again

Nicolas Sarkozy certainly likes the spotlight. And he intends to capitalize on his short time as chairman of the G20. And while he seems to be on point about the potential for global imbalances to reassert themselves and wreak havoc on the global economy, he prefers a heavy-handed approach. Unlike the notoriously laissez faire China and Timothy Geithner.

Ok, maybe China just doesn’t want others dictating that which China’s state would prefer to dictate. But US Treasury Secretary Timothy Geithner made this somewhat unusual (for him) comment. Speaking at exchange-rates and capital controls, he offered:

This is the most important problem to solve in the international monetary system today. But it is not a complicated problem to solve …

It does not require a new treaty, or a new institution. It can be achieved by national actions …

National actions, huh? Interesting. Maybe he just wants to let Sarkozy play the New World Order role while he has the microphone. Even though he somewhat countered this by offering that the IMF should be given an increasingly important role at dictate global currency policy, we do like the idea of “national actions.” We also like this from him:

We believe that currencies of large economies heavily used in international trade and financial transactions should become part of the SDR basket, and that to achieve this objective, the concerned countries should have flexible exchange rate systems, independent central banks, and permit the free movement of capital flows.

The point here is that there are many unresolved issue where it concerns global imbalances. A relapse here could severely impact the optimism baked into asset markets. Sure, the world is far more aware of the seriousness here than when the global financial system erupted in 2008. But despite all the attention given to the matter, why are there still so many questions and such inability of global powers to meet in the middle?

Because it is truly about national interests. The eurozone has a hard enough time meeting in the middle in discussion regional interests. Naturally, it’s going to be a lot tougher for major world economies to artificially determine neutral global policy when countries are fighting to keep growth alive. There is a well-known community organizer here in the US – maybe Sarkozy should ask him for help. Maybe he already has.

But utopia is not to be. And refusal to adopt national policies that encourage sustainable growth, rather than a lop-sided model that has left the world unstable, is the largest risk to the markets. Perhaps it’s not the most likely risk; but it is the largest.

The risk-averse impact from a major global rethink should be supportive of the US dollar.

But for now, we still have QE2.