Tight U.S. Monetary and Credit Conditions Warn of Possible U.S. Downturn in 2003

October 28, 2002

The Euro has been essentially range-bound versus the dollar for the past four months, with the Euro's upside capped at the parity level and its downside checked around the U.S.$/E 0.96 level. A variety of crosscurrents are presently pushing and pulling this key exchange rate with roughly equal force, the end result being a trendless pattern since late June. The marketplace appears to be taking the view that this range trading pattern will continue, as evidenced by the sharp decline in the Euro's implied volatility over the past four months. Indeed, implied volatility is now close to the extremely low levels that briefly prevailed in March-April of this year.

But this trendless pattern is not likely to last very much longer. Technically, the Euro has been trading in a pennant formation since July. A pennant formation is generally regarded as a continuation pattern, not a reversal pattern. Fundamentally, we expect that economic forces will soon kick in to drive the Euro to new highs for this cycle. The most worrisome sign for the dollar is the rising risk that the U.S. economy might slide into a double-dip recession in the coming months. As we reported two weeks ago, our U.S. monetary and credit conditions index has moved into highly restrictive territory in 2002, reflecting a slowdown in U.S. monetary-base growth, a flattening of the U.S. yield curve, a widening in credit spreads, a sharp decline in equity prices, and a steady decline in bank lending and commercial paper issuance. (Deutsche Bank's monetary and credit conditions index is an equally weighted index that tracks the trend in U.S. monetary-base growth, banks' commercial and industrial loan growth plus non-financial commercial paper issuance, the Wilshire 5000 equity index, the U.S. Treasury Bill rate, the 10-year/three-month Treasury yield curve slope, and the Baa corporate/Treasury bond yield spread.)

Historically, our U.S. monetary and credit conditions index has served as a fairly reliable leading indicator of bank lending standards as reported in the Federal Reserve's Senior Loan Officer Opinion Survey (see Figure 1). (The Fed normally conducts its survey four times a year, although in certain difficult periods, it may conduct up to six loan officer surveys in a 12-month period.) The survey asks senior loan officers at approximately 60 banks whether their standards for making commercial loans have eased or tightened since the previous survey.

Figure 1
U.S. Monetary And Credit Conditions Index And The Fed's Survey Of Lending Tightening
(Senior Lending Officers Survey-Large Business)

Source--Datastream

In recent research by the Federal Reserve Bank of New York (FRBNY Economic Policy Review, July 2000), it was found that the Senior Loan Officer Survey has been a useful indicator to help predict future changes in U.S. economic activity. Indeed, five out of the past six U.S. recessions were preceded by sharply tighter credit standards. (Note in Figure 2 that the tightening in bank lending standards in 2000 correctly anticipated the U.S. recession of 2001, and that the modest easing in bank lending standards in 2001 correctly anticipated the modest recovery in U.S. growth so far in 2002.) For the one recession in which the survey failed to predict the onset of a recession-the 1981-82 downturn-bank lending standards did not tighten prior to the onset of the downturn but actually tightened as the economy entered the contractionary phase.

Figure 2
U.S. Bank Lending Tightening And U.S. Recessions
(Percentage Of Banks Reporting Tightening Of Lending Standards, 1990-2002)

Source--U.S. Federal Reserve, Datastream

As suggested by the rise of our monetary and credit conditions index into restrictive territory, there is a very good chance that the next Fed senior loan officer survey, which will likely be conducted in November, will indicate that banks significantly tightened their lending standards in the most recent period (see Figure 1). That would suggest there is a significant risk that the U.S. economy might enter a new recession, perhaps in 2003.

Our monetary and credit conditions index is not the only indicator pointing to weaker U.S. growth in the coming months. The Philadelphia Fed's diffusion index of manufacturing activity fell sharply in October to -13.1 from +2.3 in September. As shown in Figure 3, this is the lowest reading for the Philadelphia Fed index since November 2001. Note that the sharp decline in the Philadelphia Fed index in late 2000/early 2001 correctly anticipated the U.S. recession of 2001.

Figure 3
Philadelphia Fed Diffusion Index of Manufacturing
(And U.S. Industrial Production)
(Year-Over-Year Percent Changes)

Source-Datastream

Other leading indicators might be hinting of a U.S. slowdown as well. The Conference Board's leading economic indicator has declined for four consecutive months, and the OECD's leading indicator of the U.S. economy has declined for the past three months (see Figure 4). (Note that the OECD reported that the trend-restored six-month rate of change in its leading indicator of the U.S. economy has fallen from a high of 4.5 percent in April to a mere 1.6percent in August, the latest month of data.)

Figure 4
OECD Composite Leading Indicator Of U.S. Economic Growth

Source-Datastream

Although a renewed downturn of the U.S. economy in 2003 would have a negative effect on the dollar overall, the dollar might receive some positive residual side benefits as well. On the negative side, a U.S. downturn would probably force the Federal Reserve to cut U.S. short-term rates aggressively to counteract a possible trend toward sustained U.S. economic weakness. This would likely lead to a further widening in Euroland/U.S. short-term yield spreads, which would clearly be bullish for the Euro.

On the positive side, the dollar might benefit indirectly from a downturn-induced narrowing of the U.S. current-account deficit. Downturns in U.S. economic activity normally coincide with periods of narrower current-account deficits (see Figure 5). Indeed, it often takes a major slowdown in U.S. economic activity to make meaningful headway in reducing U.S. current-account shortfalls. The most recent example of this was last year. As shown in Figure 5, the U.S. current-account deficit narrowed during the 2001 downturn, but then rose again in 2002 once the U.S. economy recovered.

Figure 5
U.S. Current Account And U.S. Recessions

Source-Datastream

With the U.S. current-account deficit hitting a record 5 percent of GDP in the second quarter and with the risks pointing to still wider deficits in the future, the dollar would appear to be highly vulnerable unless the current-account deficit narrowed independently of exchange-rate changes, i.e., via a significant slowing of the U.S. economy. If so, then at least some of the potential downward pressure on the dollar might be removed in 2003 by trends in U.S./global relative economic growth.

Although economic downturns are not the desired route to restore balance of payments equilibrium in any country, it might be the only viable course open to restore the U.S. current-account balance to a sustainable level. Normally, a country would rely on a balance between exchange-rate depreciation and relatively slower economic growth to help narrow an unsustainably large current-account deficit, but the dollar depreciation route might not be open to the U.S. this time around. The reason why this might be the case is that the U.S. is presently running large bilateral trade deficits against several key countries whose currencies are either rigidly pegged to the dollar or are unlikely to strengthen against the dollar by a meaningful amount.

Consider Figure 6, which breaks down the countries with whom the U.S. runs large bilateral trade deficits. The pie chart shows that 21.5 percent of the overall U.S. trade deficit is with China, 11.3 percent with Canada, 8.6 percent with Mexico, 7.9 percent with the Pacific Rim countries (excluding China), and 7.1 percent with OPEC members. (Another 8.8 percent consists of deficits against smaller countries in Eastern Europe, Africa, and elsewhere.) Combined, these countries make up nearly two-thirds of the total U.S. trade deficit. The key issue is whether it is realistic to expect that any of these countries' currencies might rise by a meaningful amount versus the dollar to correct their respective bilateral trade imbalances. The answer probably is "no". That leaves the brunt of the adjustment to Euroland and Japan.

Figure 6
U.S. Trade Deficit By Region (2002)

Source--National Accounts Data

Japan's bilateral trade position versus the U.S. accounts for 15.4 percent of the aggregate U.S. trade deficit. One could argue that a stronger yen would help narrow the U.S. trade deficit. But the yen is more likely to weaken, not strengthen, against the dollar on a trend basis, as has been the case for the past 7-1/2 years, given Japan's persistent and highly serious internal-balance problems.

That leaves us with only the Euro to play a meaningful corrective role. Euroland's bilateral trade position versus the U.S. accounts for 14.7 percent of the aggregate U.S. trade deficit. (If we add all other European countries that are not members of Euroland into the mix, then Western Europe as a whole accounts for 19.4 percent of the aggregate U.S. trade deficit.) While we believe that there is scope for the Euro to move significantly higher versus the dollar on a trend basis, one needs to be realistic that a trend appreciation of the Euro alone will not make a meaningful dent in the widening U.S. trade deficit. Hence, it appears that changes in relative U.S./overseas economic conditions, and not the dollar's value, are likely to play a more important role in correcting the unsustainably large U.S. current account deficit in the months to come.

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