European interest rate cuts are inevitable in coming months and bond yields are likely to tumble as the high and over valued euro wreaks damage on the European economies. In contrast US and Asian economies will be boosted by the effective devaluation of the greenback and Asian and other dollar bloc currencies.
When the market is in this sort of mood, it is dangerous to bet against the crowd. If the market pushes the dollar down further, prices of gold and other precious metals will jump and the commodity speculation bubble could well expand < http://www.marketpredict.net >. The Federal Reserve Board may well surprise the market and push rates up sooner than expected. If market forces fail and the market becomes volatile in the final stages, central bank action to support the greenback is likely. Those moves, plus the relative strength of the US economy, will eventually stop the rot, but the $64,000 question: at what rate?
Overshooting down and up in the past three decades
In what central bankers and foreign exchange dealers describe as the "overshooting" phase, it is exceedingly difficult to predict the bottom of the dollar. We've been there before. Under the Carter Administration in the late seventies, the dollar weakened substantially, but then inflation was rampant. When Federal Reserve Board governor Paul Volcker tightened money and raised interest rates at the end of the seventies, the dollar began to recover from its slump. Few believed in the dollar bull market at the time, but it continued to rise.
From the beginning to the mid-eighties, the effective dollar exchange rate soared by almost 80 per cent. By 1985 it peaked and helped by the Central Bank "Plaza Accord" the following year, it continued to depreciate, slumping to the low of that cycle by late 1989. It rallied once again and at the end of 1993 began a steep 15 month descent that knocked off 20 per cent off the trade weighted index, falling far more against the yen, Deutsche mark, Swiss franc and sterling.
In the subsequent dollar bull market, which began in 1995 and was accompanied by extensive economic expansion and a remarkable stock market boom, the trade weighted index soared by around 50 per cent to its heady heights in 2000. Since then the dollar wind has blown south. The currency has tumbled by 28 per cent from its top.
Logical fundamental analysis and charts are useless in overshooting phase At current levels, experienced knowledgeable currency economists with proven long term track records, such as Tokyo Mitsubishi International's Brendan Brown, believe that the dollar is undervalued . He and several others maintain that it has already over shot the mark.
But when a currency is out of fashion in a foreign exchange market with daily trading volumes of $1.5 trillion, logical economic and currency analysis < http://www.marketpredict.net > isn't much use. Technical analysts claim they have the answer, but similar to fundamental analysis, much depends on the subjective talent, experience and luck of the individual Chartist. The track record of the majority of Chartists, since free floating currency markets began at the beginning of the seventies, hasn't been impressive. The market is driven by sentiment and sentiment rules. Once again the US current account balance of payments is the cliché reason for the dollar's demise. Countless reports repeat the boring platitudes and statistics, which surely by now are reflected in the current depressed rate.
The US balance of trade has been in deficit for years and that gap didn't stop the currency from surging in the eighties and nineties. Foreign trade is only a small proportion of the market that is dominated by cross border money and capital flows ruled by confidence or lack of it thereof. Purchasing Power Parity e.g. the famous McDonald's hamburger price comparison, isn't worth a row of beans.
What is certain is the bearish dollar sentiment. As one hedge fund manager noted: " Today good, bad or neutral US economic news is used as an excuse to sell the dollar". A recent survey of more than 100 major European asset managers showed that the overwhelming majority expect the dollar to weaken further. Most traders and market strategists have the same view.
Extent of the devaluation ignored market participants are ignoring the substantial dollar devaluation that has already taken place. This year alone, the dollar index slide has been 14 per cent. Since the end of 2002, the dollar has plunged by 18 per cent against the euro, by 14 per cent against the yen, 12 per cent against the Swiss franc and sterling. Gold and commodities have soared in tandem with dollar weakness, and likewise for the Canadian, Australian and New Zealand dollars and South African rand. The dollar has weakened slightly against Asian Dragon currencies such as the Singapore and Hong Kong dollar and Korean won. Asian central bankers have carefully managed their currencies and China's renminbi is still level pegging with the dollar. Thus the Asian bloc is effectively a dollar bloc and has devalued in tandem with the greenback.
European and other nation exporters and their economies are thus under considerable pressure.
Vicious circle as bears seek another 10 per cent plus decline In central banker speak, the dollar is in a "vicious circle" and currency traders have in their sights the dollar's 1995 nadir. Such depths would place the dollar index around 80 or about 10 per cent below present levels. In those circumstances, gold would rise to around $450 an ounce, driving silver and platinum upwards.
Reasons and history of the 2000 to 2003 dollar bear market How did the dollar slide come about? In the late nineties, the dollar was riding Wall Street's stock market boom and foreign money poured in. It was thus overshooting on the upside, so it was not without coincidence that it peaked in 2000 when the stock market bubble burst. The second major event was September 11, causing a US economic recession. The US Federal Reserve Board and the Bush Administration therefore had a single aim, notably to counter the economic and Wall Street slump. The Fed raised money supply and slashed interest rates while the Bush Administration cut taxes, a classic Keynesian reflationary policy. Meanwhile wars in Afghanistan and Iraq damaged business confidence, causing further interest rate cuts and a big increase in the government's budget deficit. Oil prices rose and imports poured in from Asia as the American economy outperformed its European counterparts. The balance of payments current account deficit thus rose substantially. Less capital flowed in to finance the deficit and global investors switched out of dollars into euro and other currencies. In an anti-American move, Middle Eastern investors sold dollars. The inevitable result was a greenback downturn.
Misreading the American and International psyche when assessing the dollar The biggest mistake made by foreign exchange analysts and traders is to fail to appreciate the difference between the American and international financial psyche. The average American in the mid West doesn't think about the dollar. Other than the Wall Street Journal and New York Times, dollar stories hardly feature on state and local news pages. The domestic economy is so huge that the dollar rate isn't an economic and political problem, except if it hurts business or causes a slide in the stock market. Up to now effective dollar devaluation, accompanied by low interest rates, has helped the economy to recover. President Bush is concerned about business and being re-elected again. He knows that cheap imports damage home manufacturers and dollar weakness counters foreign competition. His Administration thus attempted to place pressure on China and other nations to revalue their currencies. Policies to support American business make good headlines at home.
But for global investors, including Asian central banks, this was a signal to diversify out of dollars. This process, which began about six months ago, has caused the final run on the dollar. How will the dollar slide end?
Market forces will cause the market to turn. Global pessimism about the dollar illustrates that there are already substantial dollar bear positions. There have been extensive "carry trades" by hedge funds and other players. They have been borrowing dollars and yen at very low interest rates and have invested in euro, sterling and commodity currencies, notably the Canadian, Australian and New Zealand dollars and the South African rand, which is a quasi emerging market currency. These players will have to take profits at some point by purchasing back dollars.
They will need an incentive. The difference between the current dollar bear market and previous ones is that the Fed hasn't begun to raise interest rates. But money supply is slowing, so it is a matter of time before it does so. Even if the Fed doesn't increase rates, US bond yields are likely to rise, while in the much slower European economy, bond yields will fall. In this way a cheap dollar will become attractive.
The average American will only begin to worry if global investors dump dollar bonds forcing bond yields upwards. This trend would bring about higher mortgage rates and other long term rates as well as a stock market and possible property slide. A volatile dollar would then no longer be benign. That's when the Fed and other central banks would act. The element of surprise is necessary and at some point, as sure as day follows night, they'll buy dollars and force it upwards. In the past central banks have caught the market unawares and have managed to wrong foot traders. Their treasurers are even more sophisticated than in the past, so they'll do it again.
In the meantime dollar bears are enjoying the band wagon. Thank heavens, the dollar decline has so far been a benign affair-unless you are a European about to lose your job. The American economy is already outperforming its weak European counterparts. The balance of payments current account deficit will begin to narrow even though the "J Curve" effect (worse first, better later) delays the process. The dollar is the world's reserve currency and the euro and yen can't be regarded as viable alternatives. The old time Gold Standard wasn't the answer. The dollar tide will (eventually) turn… the only questions are when and at what rate?
12 December 2003
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Neil Behrmann is editor of www.marketpredict.net