The Dollar Can Continue To Rally, Despite the Weak Economy

The US dollar has been quietly trending higher since the European trading session. The EUR/USD hit a high of 1.4768 Friday shortly after the London open but ended the US session near its daily lows. Although this strength was also seen against many of the other major currencies, the dollar failed to rally against the Japanese Yen. This weakness was primarily due to the move in US equities which dropped over 170 points in the US session. Oil also reversed sharply, ending the day slightly under $116 a barrel, after having hit an intraday high of 118.76.

August was a very good month for the dollar, with the currency seeing its strongest 1 month rally in more than 15 years. Although the US economy remains weak, the price action in the dollar indicates that the currency can rally even if the economy slows. Trading the currency market is oftentimes an expectations game.

Since July, the market’s expectations for growth have shifted dramatically. Over the past month, it has become increasingly clear that traders have underestimated US growth and overestimated growth outside of the US. GDP growth in the second quarter was 3.3 percent, far above everyone’s estimates.

Since April, the trade deficit has also narrowed, adding fuel to the dollar’s rally. Looking ahead, the question is can the dollar’s rally continue? The answer is a qualified yes. The rally can continue, but certainly not at the pace that we have seen over the past month. Four central banks are meeting to decide on monetary policy next week, one of which is expected to lower interest rates. Don’t expect this central bank to be the last.

The Federal Reserve has already done its work and rates are low enough that they will not be decreased again in this monetary policy cycle. Everyone else on the other with the exception of the Bank of Japan still have plenty of room to cut rates.

The dollar’s weakness in the first half of the year helped to support corporate earnings and M&A flow. The recovery in the dollar since then strips away the foreign exchange contributions which could have a negative impact on earnings in the remainder of the year. The US data released this morning was mixed with personal spending rising slightly but personal income dropping by 0.7 percent.

The Chicago PMI and University of Michigan consumer confidence numbers were both better than expected.

The shortened trading week only means a busier one. Service and manufacturing ISM are due for release along with the Fed’s Beige Book report and non-farm payrolls. The US economy is expected to see its eighth consecutive month of negative job growth.

Comments

[User 143167:]

You are right that rebounding dollar is bad for the earning growth in the US stocks. Therefore I don't know why equity bulls are so happy about that.

2008 Sep 02 05:54 AM

[gabe borens...:]

The unprecedented dollar weakness had transformed the U.S economy into the lean mean economic machine.The currency shift via the J-curve had a phenomenal (but expected )impact on the U.S exports.Certainly ,the dynamic rebound in the exports had deflected potential for recession which many experts are still talking about even as U.S is poised for a major(record?) rebound.
The problems that we had faced in the financial sector (but were and are being addressed) have had enhanced the dollar outflows further contributibng to the past weakness.
Relatively speaking from the historical perspective the recent dollar gains are insignificant to have a major (if any impact on the trade balance).In fact the J curve response to major shift in the currency relationships is very slow (at least 12 months).
More importantly ,the more recent geopolitical issues will enhance dramatically the demand for the dollar assets thereby continuing to strenghten the dollar.
In Europe ,investors have to address the reality of a more aggressive neighbor namely Russia.Clearly Europe lacks the necessary military offset to neutralize the new Russian military might (admittedly so).
Under the circumstances the investors do recognize the enhanced value of the dollar assets.
If you are a Middle Eastern investor ,you are facing not only a potential of a major socio political instability but unpredictable Iran in you vicinity.While the expressed threat is aimed at the U.S,Iran is the real threat to the established governments (kingdoms if you will) in the Middle East. That is another reason for the dollar demand .
The FX shift favoring dollar will continue for some time.TheU.S equities and the real estate sector (value assets) will be primary beneficiaries of these flows contributing to a major economic/stock market rebound in the period ahead .Europe in the process of deceleration, is likely heading for a recession and still will have to face its own issues in the financial sector(further strenghtening the dollar).
Dollar at par with Euro is reality as is unprecedented U.S economic rebound fuelled by the accelerating demand for the dollar(or dollar denominated assets.)

2008 Sep 02 07:24 AM

[Lou Thomas:]

As you say, the U.S. economy remains weak - actually it grows weaker by the day, and in very dramatic ways, ways that haven't been seen since the Great Depression. And yet, the dollar has rallied despite this.

What is your comment? "Whoa, look at that dollar go, even though the economy is tanking!"

I'm wondering why you are not instead stating that the fundamental weakness of the U.S. economy augurs against a continuing rise in the dollar's value against other currencies, and identifies the recent rise as an aberration rather than a trend. We should beware of chasing the chart, rather than giving a true prediction, through analysis, of what the dollar is likely to do next. This brings to mind those boilerplate statements that warn us that past performance is not a guarantee of what will happen in the future.

You cite the 3.3% increase in U.S. GDP during the second quarter. However, that number is not properly adjusted for inflation, which was at the highest levels in 17 years. As the London Financial Times relates,

"The true story on these GDP reports is the dubious use of the "deflator," the inflation number that government subtracts from nominal growth to derive supposedly "real" growth. The GDP deflator they use is far lower than other inflation measures, which, if used, would reveal negative real growth."

(see business.timesonline.c...
titled "US GDP rise gives false recovery hope")

That's right - *negative* real growth, when properly adjusted for inflation.

As for the decrease in the trade deficit, that was in June, and was based upon a weakening dollar. The U.S. trade deficit stands at over 5 percent of GDP. According to the IMF World Economic Outlook report of this past April, a sustainable deficit would be between 2 and 3 percent. That is at least 40 percent less than the present deficit. June's decline in the deficit was 4.1 percent of the deficit, so the dollar would have to continue falling from where it was in June sufficient to trim at least ten times that amount from the deficit before the dollar could stabilize.

I would also note that the increase in exports that created the change in the deficit may itself be unsustainable, as U.S. manufacturing has been cored out over the past couple of decades through the relocation of plants to cheap labor havens under NAFTA, CAFTA, APEC and so on.

You write that "The Federal Reserve has already done its work and rates are low enough that they will not be decreased again in this monetary policy cycle. Everyone else on the other with the exception of the Bank of Japan still have plenty of room to cut rates."

Are you saying that because rates in the U.S. have gone down, now they are likely to go up? And are you saying that because rates in Europe have gone up that now they are likely to go down? That hardly deserves to be called an argument. Surely we must consider the specific economic and inflation-related factors before making such a judgement.

You end by saying that the dollar's recent strength may not be good for the U.S. economy. This is true, but the problems of the U.S. economy are much more serious than that. We are talking about an economy that is dependent upon constant foreign infusions of investments and credit. The kind strangers who are extending that credit have reasons of their own for doing so, and as the U.S. economy implodes, while inflation grows in China and elsewhere, some of those reasons are starting to look less convincing.

2008 Sep 02 08:01 AM

[hedgeman:]

USDJPY has to rally above 113.00 and close the month of September above 113.00 for the USD rally to have more legs (not a likely scenario at present in our view). The dynamics of the upmove of DX is astonishing indeed and probably has further to go. DX has room to 81ish through EUR and GBP fire sales. There should be an interim correction to 75.50 - 76.00 levels first if 81 should be seen.

Meanwhile JPY is quietly setting the stage for a rally and JPY will be the winning currency in the 12-18 month frame.

Disclosure: short EURJPY and USDJPY.

2008 Sep 02 08:03 AM

[Matt from Q...:]

I just read the September issue of Futures magazine. In there, you said "the eurodollar would probably remain in the 1.56 to 1.60 range," and that the pound will remain "above 1.97."

You call yourself an "expert" (it says so right on your site) so what your headline should really be is "Why i was so wrong about currencies!"

And if you don't publish an article on here about why you were so wrong, I'm going to write about that on every forex forum I can find.

2008 Sep 02 08:17 AM

[Matt from Q...:]

I've been short the euro since about 1.53 and the pound since 1.90. Now I'm afraid that you've put the kibosh on the dollar!

2008 Sep 02 09:36 AM

[Matt from Q...:]

Anyway-I hope not

2008 Sep 02 12:02 PM