THE U.S. BOND MARKET AND THE DOLLARPrepared by Michael R. Rosenberg, Deutsche Bank AG
Foreign Exchange Research Department
(May 19, 2004) At the beginning of the year, we thought the dollar was oversold and was ripe for a technical correction. The dollar's correction now appears to have been more than just a technical correction, as higher U.S. rates and an improvement in capital inflows into the U.S. and a stabilization of the trade deficit all provided the dollar correction with stronger legs. Yet, the correction has probably taken things a little too far.
U.S. interest rates have generally trended higher over recent months, and as a result the U.S./foreign yield spreads widened. Net private foreign capital inflows were moving back into the U.S. and the U.S. trade balance appeared to be stabilizing. Therefore, if you factor in higher U.S. rates and wider spreads, and improvement in capital inflows and the stabilization of the trade balance, the dollar was on a stronger footing.
Recent activity, however, may be throwing up some caution flags on the dollar rally. First, U.S. bonds appear to be significantly oversold. That's evident in RSI readings, which are in the low 20's, and in market sentiment surveys, such as the Consensus Inc. survey, which indicate extremely bearish sentiment for U.S. bonds. Even though we remain negative on the long-term outlook for U.S. bonds, the fact is that the market probably got a little carried away. As U.S. rates move down again and as U.S./foreign yield spreads narrow, some of the steam will be taken out of the dollar rally.
The U.S. basic balance of payments is also suggesting a weaker dollar now. According to the latest Treasury data on net private foreign purchases of U.S. securities, foreign purchases of U.S. corporates picked up from $21.3 to $30.3 billion, but net foreign purchase of U.S. agencies dropped from $24.3 down to $4 billion. Equities swung from a $2.4 billion net purchase in February to $13.5 billion in net sales in the month of March.
Modified U.S. Basic Balance Of Payments And The Dollar
(Total Purchases Excluding Treasuries)Note: Net foreign purchases of stocks and bonds
(excl. Treasuries) less the U.S. Trade Deficit
Source: Datastream, U.S. TIC
Overall, net private foreign purchase of U.S. corporates, agencies and equities dropped from $48 billion in February to $20.8 billion in March at the same time the trade deficit widened during March, from $42.1 billion to $46 billion. That means that our basic balance of payments indicator swung from a surplus of $5.9 billion in February to a deficit of $25.2 billion in March, clearly a negative for the dollar.
Also, the trade balance experienced a significant deterioration, going from $42.1 billion to $46 billion in March. This was an across the board deterioration against most major countries and regions. Petroleum added to the widening of the deficit, given the recent rise in oil prices. When we start getting the April and May data later on, with even higher oil prices now in the pipeline, the trade numbers are certainly going to get a lot worse.
2004 is shaping up to be an extended period of dollar stabilization and a correction of the oversold readings in the big dollar drop that occurred over 2002-03. A lot of the factors that were dollar positive have turned the other way, so some of the fundamental support for the dollar may be beginning to ebb.
The future fiscal/monetary policy mix for the U.S. is a case in point. According to the OECD's latest economic outlook report, the fiscal stance in the U.S. is expected to contract by 0.7% next year, which would be the first year of fiscal contraction in the U.S. in the last 3-4 years. If you couple fiscal contraction with a move towards a tighter monetary policy, that's not a good recipe for economic growth in 2005. Thus we could see economic activity in the U.S. begin to slow in 2005. Even though higher rates and wider spreads would be positive for the dollar, peoples' expectations of future U.S. growth prospects would begin to weaken. That could have an adverse effect on overall capital flows, particularly on equity flows.
As for the yen, the OECD sees Japan's current-account surplus rising from 3.1% of GDP last year to 3.8% of GDP in 2004 and rising to 4.4% in 2005. That would be more than a 20-year high on the current-account surplus for Japan, which would be bullish for the yen. Most of that gain in Japanese exports is not coming at the expense of the U.S., however, as most of that improvement in Japan's surplus will probably come from trade with China.
It's interesting to note that interest rates in China, which are now around 5%, and nominal GDP in China is probably running close to 15% year-over-year. Normally, in the U.S. and other countries, interest rates and nominal GDP tend to move together. The fact that you've got such rapid nominal GDP growth in China, three times more rapid than the level of interest rates in China, suggests that monetary policy in China is extremely easy. Even though there's talk about monetary conditions tightening in China, the fact remains that the huge gap between nominal GDP growth and the level of interest rates in China is not likely to be closed any time soon. As long as China continues to grow at a relatively healthy clip, Japan is well positioned to see its current-account surplus continue to rise, and that should be yen bullish over time.
To sum up, the dollar remains in this long-term consolidation pattern. We've been in it since January and now it's running into May. Part of this was technical, but part of it was fundamental. Some of the fundamental source of dollar firmness is beginning to ebb at the moment, given the recent easing in long-term rates in the U.S.--in an oversold bond market--and the worsening of the U.S. trade number.
Note that these are just one-month changes and we're going to need more evidence to see whether the fundamental picture is getting back to the long-term bear market trend or if this period of dollar consolidation will continue for a lot longer. Right now, the big trade is being short U.S. bonds. For FX exposures right now, the risk/reward profile of being long or short the dollar against the Euro is not that high. I would wait for the U.S. bond market correction to work itself out and then I'd get short U.S. bonds in a major way.
May 19, 2004
Michael R. Rosenberg
Deutsche Bank AG
60 Wall Street, 18th Floor, New York, New York
P.O. Box 520526
Independence MO 64052-0526
Email this Article to a Friend