Long and Wrong!
We entered the year expecting the dollar to find support on two primary drivers that is the mother’s milk for currencies:
Sounds crazy given that we knew:
a. US housing prices were still tumbling
Case-Shiller US House Prices Index:
b. Job growth was still not pretty, yet showing some improvement
c. Federal spending is a train wreck in the making (already made) to say the least
d. State and local governments are in big trouble as tax revenues plunge exposing their largesse (those $150k/yr fireman, city assistants, and other assorted union jobs in jeopardy; Mr. Market doing some overdue cleansing there.)
e. The Fed is still around; unfortunately we
seem stuck with that 13-headed beast to do all it can to misallocated capital and screw up market signals sending money to its friends at the banks, and others along the food chain at precisely the right (read: wrong) time.
But, before you breakout into laughter, given that the dollar index has been steamrolled thus far in 2011, let us fit the other shoes …
This is a relative game, therefore:
Relative to the eurozone, US growth we think has an edge (as much as we hate both QE 1 and QE 2 as policy tools in place of real reform, i.e. the Obama government can’t seem to get serious about the Federal budget given all the union members and cronies he must still pay off; of course the Republicans now have religion, but they didn’t seem to be big believers while George Bush was in office; he was a man who never met a spending bill he didn’t like, doing his best to destroy the Republican party from the inside—he did a darn good job at that. So we are left with both these sets of clowns to solve a problem both have benefited from—not a pretty picture. Thank goodness our votes do still seem to matter at least at the margin; and it is at the margin where the serfs are rising up. This problem seems to have gathered critical mass with real people, this means politicians that wish to increase their chances of re-election, always their number one goal, will have to take cutting the deficit seriously.)
The European serfs are not taking it sitting down either as they watch the best and brightest at the head of the EU make a hash of it all. Progress on the eurozone stability fund fills the air with joy still. Some real progress seems to have been made. But we think a restructuring cannot be avoided. Spain is teetering, Ireland’s central bank just halved its estimated growth for 2011…Political risk fills the air…this from a very astute and nice friend of Currency Currents, Mr. Al Kingon, former US Ambassador to the European Union, responding in the New York Times magazine to an article about the problems in Europe, written by Mr. Paul Krugman:
Of course, Krugman was correct regarding Europe and the euro. When I was the United States ambassador to the European Union (then the European Communities) in the late ’80s, as preparation for the advent of the euro was taking place, the crosscurrents were strong and visible. It couldn’t possibly succeed, as predicted by many, without a finance ministry for all of Europe, not possible then or foreseeable now.
A real look at European debt, which is far greater than the narrowly reported official deficits, bodes badly. Bailouts are being affected by the imposition of rising and unsustainable interest rates. Just look at recent bond yields in Portugal, Ireland and Greece. And what will happen when more onerous austerity programs are initiated to meet new budgetary targets? Will the E.U. survive? Of course it will. It has succeeded in quelling thousands of years of internal warfare. But the euro and current E.U. structure — well, that’s another matter.
I think Al would agree with us that even beyond the inescapable structural flaws of the single currency, at this stage in the process politics may be the driving force for further entropy.
Though we are not on the ground, we think Germans are fed up with committing more to this experiment (though in actuality they have benefitted big time from it; industrialists dumping the D-mark looks quite good in hindsight; a captive market they have had; complete control they seem to be achieving). Merkel is treading lightly (can’t tout German benefits lest she let the cat out of the bag for her “partners” in the EU), but must step it up to keep the game alive, thus her most recent comment that Germany will never abandon the euro. Yeah, sure!
What happens when Germany slows? German citizen discontent will rise. From The Wall Street Journal [our emphasis]:
German export gains in China—55% in the first five months of the year , or roughly six times the growth rate of exports to the euro zone—have been the primary engine in the recovery of many German manufacturers, such as textile machinery, compressor and machine-tool makers.
And though one can never say for certain, it seems the only way Germany will continue to grow at anywhere near the blistering pace it has recently (of course creating the two-speed Europe that adds to political tensions) is if China decides inflation doesn’t matter, i.e. continues to boost lending out the “bank” door while pretending raising reserve requirements matter (a point the financial press seems to adjust their focus) and continues to buy German high-tech goods and advanced machine tools as fast as it can before German companies start seeing exact knock-offs competing with them in other markets at around half the price.
Inflation is the key word in that sentence, I will return to that in a moment.
Relative to the UK, the US would seem to have a growth edge. Jeez Louise, the UK effectively announces it is heading into stagflation (recession coupled with inflation) and its currency decides to surge higher against the US dollar. That says something very interesting about how much traders don’t like the dollar here.
Relative to Japan, the US would seem to have the growth edge. No surprise here. The surprise would be if Japan gets its economy in gear. But because expectations are so low, just maybe…we still think Japan can surprise a bit on the heels of US growth, i.e. it follows and normalizes a bit. A normalized economy is still the underlying problem for Japan. The Bank of Japan created many years of capital dislocation thanks to its zero interest rate policy. The brain trust at the Fed seems to have missed that lesson.
Nikkei 225 Index (black) versus Japanese yen (orange) Daily: It has been a tight correlation, as Japanese stocks move lower and lower, the yen strengthens. Seems a bit counterintuitive; but counterintuitive is the word you end up with when capital dislocations rule the day. Notice the divergence lately in this pair? Japanese stocks higher but the yen continues to rally against the US dollar, i.e. USDJPY goes lower.
Relative to the commodity currency countries of Australia and Canada, we would say they still have the growth edge. But of course it all depends on the 800 pound dragon in the room—China.
Okay, if US growth is materializing and all you say is true, then why the heck is the US dollar getting smacked by all comers?
US Dollar Index Weekly: Rectangle represents 2011.
Why? In a word: inflation! Real and perceived.
US Consumer Price Index:
With gift of hindsight, it appears the other central banks in the world are concerned about inflation. Nary has a peep been heard from the Fed, in relative terms … and the Fed of course thinks it is right not to get too hyped up about inflation.
Gee…what’s the fuss? Core inflation, the number that matters to central bankers who seemingly don’t eat or drive, is quite low. Well, the fuss is that there is rising concern that all that money you and your central banker friends sent out to play, is coming back in the form of rising costs for real stuff.
Now why is this reverberating back onto the US dollar given that it is now a global phenomenon? It is reverberating back because the Fed doesn’t seem to be as concerned as either the ECB and Bank of England and everyone else. Thus, we are seeing the short-term US yield differential plunging for the dollar relative to other currencies …
US-UK 6-mo Yield Spread: Despite a recession in the cards possible for the UK, its short-term yield has risen relative to the US, i.e. the falling spread shows negative yield differential for dollar deposits relative to the UK.
US-Eurozone 6-month yield spread: Ditto!
US-Japanese 6-month yield spread: Not as pronounced here …
US-Australia 3-month Yield Spread: Interestingly, US yields have actually improved relative to Australia so far this year; but there is still a whopping 4.6378% negative yield differential for the buck …
US-Canada 6-month Yield Spread: Similar to Australia, i.e. commodity currency relative yields falling despite everyone believing this is where all the inflation is coming from…hmmmm! Take a look at the divergence between Chinese stocks and copper below…something nagging there …
Shanghai Composite Index vs. Copper Futures: a big divergence in the tightly positive correlation appeared in November 2010. Copper is now making new highs; Chinese shares are peeking out above downtrend channel resistance. Will Chinese shares follow copper, or are shares leading a long-term turn lower that copper traders thus far refuse to recognize?
So, so far our view this year has been completely wrong. We have underestimated the degree to which European central banks would make noise about hiking interest rates in the face of a very nasty growth backdrop. And we underestimated how damaging this juxtaposition with the dovish Fed would damage the relative short-term yield differential for the buck against the euro and pound given the ability, but proof is in the pudding of course, for the US to substantially outgrow both eurozone collective and UK in 2011.
Friday, we get a look at one of the key problem areas in the US—jobs. What if it is better than expected? Does this then lead to the Fed finally making some noise on inflation concerns? Maybe just for grins the Fed can mention that QE 2 just might be enough? [This would be the best outcome for the dollar and the yield growth story we have been telling. We would expect a dollar bid on this backdrop.] But expectations are only guesses about the future, and we are painfully aware of how that can turn out.
So what if Friday’s job number is worse than expected? The question is how much worse? If it is something really ugly, then all the warts growing on the US economy come back into view big time. And as we talked about in our Forecast issue—US demand is linkage numero uno (Spanish lingo to show just our vast cultural diversity), i.e. if US demand is in jeopardy, the whole game is in jeopardy. It ripples to the 800-pound Dragon and then to the German juggernaut. A good reason for the market to stage that 10% correction many expect. Dollar gets a major risk bid just when everyone thinks it is headed for a dirt nap and euro on the way to $1.40 as done deal. Oh you are wily Mr. Market!
Or, maybe on Friday jobs are at or near consensus. Effectively meaning the US is muddling through. And of course that followed nicely by a Fed speaker on CNBC to utter about the continued need for QE2 since, “we can’t afford to let up.” *Yes. Insane is continuing to do that same thing and expect a different outcome; but we knew the Fed was insane a long time ago.] The US dollar likely continues to tank as the yield spread continues to deteriorate.
Of course, there are many other options and outcomes in between. For now, the dollar trend is clearly down, some key levels broken overnight. Let’s see if the Tao of markets rears its head. That is, the moment when we can conceive of the most risk it is usually the time when it was least risky to move. But none known till the gift on hindsight is bestowed upon us.