Outlook for the US dollar

The cyclical world is one where the dollar is driven by everyday data, this data drives interest rate differentials and hence the exchange rates. The structural world is one in which the dollar trades on the issues of the twin deficits that is the current account and budget deficits.

It is possible that both happen simultaneously but this is not the case at present, which means that once the current de-rating is over the dollar should stabilise.

How does one differentiate between these two worlds? To this end we constructed an indicator that is purely cyclical. In a cyclical world where interest rate differentials are a prime driver we constructed an interest rate differential of the US against its trade-weighted partners. This is then compared to the trade weighted dollar.

One can clearly see that interest rate differentials have a substantive influence on the trade weighted dollar. What is also clear is that the dollar fell 10% in trade weighted terms following the Dubai G7 without any associated change in interest rate differentials.

It was this de-coupling of rate expectations and the dollar that signalled the market was de-rating the dollar on structural grounds post the Dubai G7. However, once completed and after the upside surprise in the non-farm payrolls in April the market began to price in rate rises in earnest.

At this point the market started to trade on a cyclical basis and the relationship between interest rate differentials and the dollar resumed. It is also worth noting that after the G7 Dubai last year the dollar fell 10% without any change in the associated interest rate differential.

However, once this de-rating came to an end then the cyclical factors became influential again. The structural de-rating of the dollar saw euro-dollar move from around 1.09 to 1.24 in December 2004 a 14% move.

The further move up in euro-dollar towards 1.30 late last year was due to disappointing US data and cyclical factors. The move from 1.24 to around 1.2925 soon unwound as US data improved.

We monitor this relationship on an ongoing basis and our suspicions were aroused last month when retail sales were stronger than expected and the dollar fell. At this point the market started to trade on structural issues and we had indicated that we believed the situation had changed and full confirmation of this arrived with October's payroll data.

We can clearly see the de-rating that is currently occurring. Of course we still have two different influences on the dollar - stronger data and hence higher rate expectations that work for the dollar with the structural aspects moving in the opposite direction.

If they were both in the same direction that is a structural de-rating and extremely poor data then it would be difficult to call an end to this move. That the Fed is determined to raise rates regardless of the data is a supporting factor for the dollar.

We calculated that this 'normalisation premium' favours the dollar to the tune of about 5%. Before the last FOMC meeting - and looking at the data alone - one would normally be expecting a cut and before this week's meeting the Fed should be keeping rates unchanged.

This rate hiking cycle regardless of the data is extremely dollar supportive. If the Fed were to pause in December (something we are not expecting) or admit that rates have been normalised and stop raising rates regardless of the data then the dollar could fall another 5%.

We feel if the dollar is reacting to structural issues then the dollar needs to fall across the board - of course the path of least resistance is a higher euro.

This means that if a lower dollar rather than a deep recession is the best policy in order to rectify the imbalances then dollar Asia has to fall in tandem with the euro-dollar move. The question is if the dollar is to do the adjustment to stem the current account deficit how far would it have to fall?

How low can it go?

Last year we wrote 'The dollar; how low can it go?' where we looked at how low the dollar would have to fall to start to see an improvement in the current account balance.

The reason our methodology comes up with very big falls in the dollar, is that we continued to expect the US economy to grow significantly faster than the rest of the industrial world. Thus any prospect of a narrowing current account imbalance would require the dollar to do all the work.

On a structural analysis we estimated it would take a further 20% decline in the dollar's trade weighted index in order to generate a narrowing of the current account deficit by ½% of GDP in late 2006. The levels for the euro and yen implied by a further 20% decline in the dollar index appear to be extreme, and we would hesitate to forecast them.

However, the structural analysis suggests that the risks for the dollar continue to be skewed heavily to the downside.

Historically for a given move in the trade weighted index the euro moved by more than the yen, and both moved by more than the trade weighted index. If the dollar index were to fall by a further 20% and the euro and yen were to move in the same way as they have on previous occasions, this would imply a EUR-USD rate above 1.65 and a USD-JPY rate below 85.

This is not a forecast, but gives an indication of the pressures when the FX markets focussed on structural factors alone. Most investors equate strong GDP growth with a strong currency. Intuitively this seems to makes sense.

The problem is one cannot buy GDP growth as one has to buy an underlying investment associated with that GDP growth. From 1996-2000 this was certainly the case as strong growth propelled the equity markets and the low inflation environment reduced the cost of capital - the by-product of relative strength of the economy was an ever-growing current account deficit.

During this period the current account did not seem to matter as investors were being compensated with superior returns for holding US assets. The problem is that returns are dynamic and ever changing - so once the equity bubble burst and yields on the long end fell to below 4% the world then turned lukewarm on US assets.

The desire for US assets changed irrespective of superior US GDP growth and the current account deficit continued to get bigger. So for the dollar just to stand still the world needed to buy ever-increasing amounts of US assets but these profit maximising investors started to slow down their purchases of US assets.

This put the dollar in a tailspin in 2003 and to stop a brutal fall in the dollar governmental authorities stepped in to buy the dollar. This for example saw Japanese FX reserves rise from around $478bn at the beginning of 2003 to $826bn some 14 months later, a rise of around $350bn.

Central bank billions

Despite the billions poured into the dollar by the central banks in 2003 and the early part of 2004 - the dollar in trade weighted terms still fell around 15%. This leads us to believe that without such interventions the dollar could have been in crisis last year - furthermore it may also mean that the current spot exchange rates are set by a mixture of state intervention and free markets.

Thus if central banks were to step away from the market - one could see lurches in certain currencies as they find their free market value. As far as reserves are concerned starting from 1960 it took the world 34 years to increase FX reserves by $1 trillion, it then took a further nine years to increase another trillion, the last trillion took 18 months.

Growth becomes a negative

So if the superior growth in the US is not leading to superior returns but is leading to an ever-growing trade deficit then the pressures on the dollar remains acute. This year despite superior growth the S&P500 is up around 5% compared to around 4% in Eurozone equities and around a 3% increase in the Nikkei.

Furthermore the build up in reserves by foreign central banks last year was a one off flow and into the future it works against the dollar. Into the future the US pays coupons/dividends on these fixed income instruments that are bought with the intervention money and it results in a constant drain on the dollar.

We expressed this in the last currency outlook in the piece entitled 'The US external deficit spiral'. Here we pointed out that the US overseas net asset position is worsening rapidly and a deficit on overseas investment income will soon add to the growing trade deficit, this makes the current trajectory of the US external deficit genuinely unsustainable.

The problem is that if one of the great positive points for the US and the dollar has always been strong growth but this strong growth has now turned into a negative. Instead of bringing superior returns it brings a bigger trade deficit and bigger structural problems and under this scenario the market will sell the dollar despite strong data.

We already had a hint of this last year and this seems to have returned as a major theme in the markets as the dollar fell recently despite some very impressive employment data in the US. If this line of thinking becomes further entrenched then the dollar will come under ever increasing pressure and there is not much policy officials around the world can do about it.