U.S. Policy Failures Weaken Dollar: Buy Pound Sterling?

 |  Includes: FXB, FXE, UDN, UUP
by: Ralph Shell

Only a week ago, the two US political parties were battling over the budget size, the debt ceiling and the timeline for the implementation of Obamacare. Washington observers should not have been surprised with the eleventh-hour fix for the budget and the debt issues. After all, most complicated issues are not settled until the deadline approaches. Refusal by the Democrats to compromise on delaying the beginning of Affordable Care Act was no surprise.

The introduction of this healthcare law has been a mess of monumental proportions. Every day there are reports of new problems with the law. Tuesday, 300K policy holders in Florida lost their existing insurance because the plan did not comply with new regulations. Why the Democrats did not eagerly accept the Republicans request for a delay is a mystery.

When the Washington settlement became known last week, the USD commenced a sell-off. Traders suddenly came to the realization there would be no quick decline of the amount of debt purchased by the Fed. Actually the taper expectations had been more an act of faith rather than a new policy that was etched in stone.

Then, too, the US recovery may have been a mirage. Economic numbers coming from Washington yesterday reduced that perception. The Non-Farm Report illustrated the paucity of job creation, another reason for traders to fear there will be no slowing of Bernanke's bond buying until after he is gone. Again, more bear USD news.

There are a number of reasons why the US economic recovery is so slow. It can be argued uncertainty of the costs of Obamacare for small business is a big handicap. Most new employment comes from small business, and they have not been hiring full time people because they cannot understand the Affordable Health Care Act and what will be their responsibility to make it affordable.

Numerous new regulations, many passed by executive order, hurt business. Often, these are controversial and would not be passed by Congress. The EPA is noted for issuing its own mandates with little interest in whose property is hurt by its actions.

Finally, there is the issue of corporate tax. At 40% the US has the highest corporate tax in the world. Does anybody think there will be any relief from the current administration that would encourage growth?

That leaves the US with only monetary policies to do the heavy lifting and stimulate a recovery. In an article, Federal Reserve Policy Failures are Mounting, Dr. Lacy Hunt explains his views:

"The Fed's capabilities to engineer changes in economic growth and inflation are asymmetric. It has been historically documented that central bank tools are well suited to fight excess demand and rampant inflation; the Fed showed great resolve in containing the fast price increases in the aftermath of World Wars I and II and the Korean War. In the late 1970s and early 1980s, rampant inflation was again brought under control by a determined and persistent Federal Reserve.

However, when an economy is excessively over-indebted and disinflationary factors force central banks to cut overnight interest rates to as close to zero as possible, central bank policy is powerless to further move inflation or growth metrics. The periods between 1927 and 1939 in the U.S. (and elsewhere), and from 1989 to the present in Japan are clear examples of the impotence of central bank policy actions during periods of over-indebtedness."

Obviously buying the USD has been a loser that has accelerated the rate of loss over the last few weeks, but is that sufficient reason to buy the euro?

Equity markets in Europe today were on the defensive. Hardest hit was the Italian Index FTSE MIB, down 2.4%. Comments by ECB President Draghi touched the sell-off when he said the stress tests for European Banks coming after the first if the year must be credible and "some banks do need to fail."

The tests are expected to show the European banks are short capital, perhaps as much as €75B. Investors remember what happened in Cyprus so replacing this capital may be difficult.

Currently, the Italian debt is growing faster than growth. This means the third largest economy in Europe has debt that has grown from 121% to 132% of GDP in the last three years. Further, Italy is now suffering from the Japanese disease, deflation. The German austerity prescription has taken another victim.

On early Friday, we get two meaningful reports at about the same time. First is the European M3 money supply, expected to be up 2.4% on the year versus 2.3% on the last report. We then get the UK GDP report expected to be up 0.8% for the quarter and 1.5% for the year. The UK is growing much faster than the euro area. The M3 number needs to be large, suggesting sufficient money for European growth.

EURGBP Daily Currency Chart

In the past four weeks, the euro has gained on the pound, from .8330 to about .8530.

Buying the pound and selling the euro (EUR/GBP, FXE, FXB) might be a way to take a short euro position without being exposed to the radical moves versus the USD. There are some serious unresolved European problems and a strong euro does not serve their interests. As always mind your money.

EURGBP Weekly Currency Chart

Click to enlarge

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.