In response to Tuesday's FOMC statement I said that the Fed's comment that it had "significant concern" about the upside risks to inflation was good news because it would help kick inflation while it's down (or moving down) and lower the chances at a revival of both the decline in the value of the dollar and the rally in commodity prices. The Fed's comment was a major blow to those who have been speculating that the Fed might consider another round of interest rate cuts in response to the weak U.S. economy. The Fed's removal of its previous comment that downside risks had diminished was far less important to the markets because it was widely expected.
The FOMC statement and the end to the Fed's recent rate cut cycle have played a major role in ending the dollar's decline. There are many other factors, and I have listed these factors, below. First let me repeat what I said at the end of May when I gave reasons, some of which are shown below, why I thought the dollar would rally by saying that I have for many years been in the camp expecting the U.S. dollar to decline in value.
My main thesis has been that the world's central banks would choose to diversify their reserve assets, which had been heavily concentrated in dollars despite the obvious changes that have occurred in the global economic scene. In 2002, for example, data from the Bank for International Settlements show that the U.S. dollar represented 70% of the world's reserve assets, while the euro represented 20% of reserve assets. Since that time, there has been a 7-point shift, to 63% for the dollar and 27% for the euro. It is quite plausible that the mix could move to 60%/30% (in the early 1990s, the dollar was about 55% of reserve assets).
The dollar rally is reversing a major negative for the U.S. economy, which will benefit more from the increased purchasing power than will result from any loss of U.S. exports.
1) The Fed toughened up: The Fed ended its rate cuts in April, paused in June, increased its inflation rhetoric, and in August said in the face of weakening economic activity and falling commodity prices that it had "significant concern" regarding the upside risks to inflation. The Fed, which until recently was behind the curve on inflation, has, by sounding tough in the face of falling asset prices globally, weakening global economic activity, and intensifying U.S. economic weakness, positioned itself opportunistically to appear to have a better handle on the inflation problem.
2) Economic growth is weakening globally: Data abound indicating weakening of global economic growth. England is moving toward recession, Germany on August 14th is expected to post a negative reading for Q2 GDP, Japan is moving toward recession, and even China is showing signs of slowing. Australia's currency has fallen nine straight days, its longest such streak since 1980 in response to weakening growth and expectations for interest rate cuts there. Relative growth patterns play a major role in determining foreign exchange rates.
3) Interest rate parity: Partly in response to signs of weaker growth abroad, the yield spread between foreign government bonds and U.S. Treasuries is narrowing. For example, the yield spread between Germany's 10-year note and the U.S. 10-year is today at 33 basis points, a 36 basis point drop from early July. Interest rate parity, which posits that interest rate spreads impact capital flows, has been an important influence on exchange rates over the past few years.
4) Purchasing power parity: The price of identical items sold in the U.S. and abroad has moved out of kilter. The Economist recently noted with its Big Mac Index that the price of a Big Mac indicated that the Euro was more than 50% overvalued. While the index almost certainly overstates the misalignment, it is difficult to challenge the notion that the dollar looks cheap on a purchasing power basis.
5) Massive unwind of commodity-linked trades: Many investors are on the same side of the market in a wide variety of commodity-linked trades and it has begun to unravel. For example, investors are long commodities, the currencies of countries that benefit from increases in commodity prices, their stocks and their bonds. In addition, many investors are invested in countries benefiting cross-border capital flows tied to increases in commodity prices (Eastern Europe, for example, which, according to the BIS, has been a major recipient of money from the Middle East). The U.S. dollar is a major safe-haven amid this major unwind.
6) Unwind of the de-coupling bet: Many investors have been betting on the idea that the global economy would be immune to the slowdown in the U.S. and many of the factors causing the slowing. Wrong.
7) Commodity drop is good for U.S. consumers: The U.S. economic outlook has improved as a result of the drop in commodity prices and anything that helps U.S. consumers has the potential to help the housing sector and hence, U.S. financial companies.
8) Change of U.S. leadership: There is much enthusiasm abroad for the prospect of a new U.S. president, particularly for the prospects of an Obama presidency. A recent Gallup poll showed that residents of the U.K., France, and Germany favored Obama by extremely wide margins, as high as almost 10:1 over rival McCain. Since most expect Obama to win, the prospect of him winning is working in favor of the dollar. An added boost is the notion that I have spoken about a number of times of Obama taking actions that put downward pressure on energy prices.
9) The Batman movie is a smash everywhere, causing a huge capital flight to the U.S.!
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Tony Crescenzi is the Chief Bond Market Strategist at Miller Tabak + Co., LLC where he advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the co-author of the just-revised "The Money Market" and "The Strategic Bond Investor." Crescenzi is a contributor to RealMoney.com.