Corporate Finance : Steadier US Rates Equal Steadier Dollar

Foreign Exchange


 

Chances for a US interest rate cut fell sharply following a string of stronger-than-expected economic data in early 2007, providing a platform for the dollar to rebound from its year-end pounding. Whether the dollar can sustain its recovery, however, will depend on a continuing stream of upbeat US economic data, analysts say.

Much like the Federal Reserve, the dollar has become data-dependent. The Labor Department’s report that non-farm payrolls increased by 167,000 in December dashed expectations of a US rate cut by July. The household survey, which includes more small businesses, shows employment growing at a much faster pace than the payroll data indicate.

The three-month moving average of job gains for the household survey in October through December 2006 was 340,000, compared to 136,000 for non-farm payrolls. Hourly earnings rose in December to their highest level since November 2000.
Positive historical revisions contributed to the surprise in December’s data, with November and October revised upward.

“The report prompted a knee-jerk reaction higher in the dollar as players were surprised at the unexpected gains in jobs, as well as the accelerated pace of wage growth,” says Michael Woolfolk, senior currency strategist at The Bank of New York. Meanwhile, the bank’s proprietary data on foreign buying of dollar-denominated securities showed an increase that was consistent with year-end portfolio reallocation, or the so-called “January effect” seen in recent years, he says.

Continued expansion in the service sector of the US economy supports the soft-landing scenario of a moderate slowing in growth with no recession, according to Woolfolk. As 2007 unfolds, consumer confidence will be key to sustained economic growth, he says.

The hint of wage inflation renews the case for another Federal Reserve rate increase, but the flow of funds into US treasury securities still looks strong from Asia, says Charles Dumas, director and head of the world service at London-based Lombard Street Research. “The US economy is not going into any kind of landing for the time being, hard or soft,” he says.

While the US economy is neither booming nor landing, the Asian savings glut is growing, as China’s net exports rise and Japan’s budget deficit is rapidly cut, Dumas says.

“The Chinese meanwhile have no option but to keep their burgeoning surplus in dollars, so long as they wish to control the yuan exchange rate,” according to Dumas. The US treasury market is acting as a global clearinghouse for surplus funds, he says.

Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York, says, “The US jobs data cap a string of impressive data that should but probably won’t silence the pessimists.” He says that the drag has lessened from two widely recognized headwinds to the US economy: housing and autos and their related sectors. Going forward, the housing market will not subtract as much from economic growth or consumer and business sentiment as it has already done, he says. “The one bet that has proven wrong time and again has been a bet against the US consumer,” he notes.

“The key to consumption in the US, we argue, is not housing, but income and credit conditions,” Chandler says. Meanwhile, cuts in auto production have helped address the inventory overhang problem, the second drag on the economy, he says. Business investment also appears to be making a positive contribution to US growth, he notes.

The dollar has been hobbled, especially against European currencies, by three main considerations: interest-rate differentials, the US current account deficit and the diversification by public and private investors away from the greenback, according to Chandler. “The diversification story has been exaggerated,” he says. “In fact, collectively, central banks hold more dollars in reserves than they did a year ago.”

At a time when reserves are being accumulated by central banks, as is the case now, reserve diversification is not a zero-sum undertaking, Chandler says, because the overall pie is growing. An important consideration in the valuation of reserves in dollar terms is the movement of the exchange rate, he adds. For example, the dollar’s decline against the euro in the first three quarters of 2006 accounted for almost half of the rise in the euro-reserve holdings in the same period, as indicated by International Monetary Fund data. Dollar-denominated reserves in the third quarter of 2006 were $252 billion more than in the third quarter of 2005.

Meanwhile, the US trade deficit has improved more than expected in recent months and has been readily financed by net foreign purchases of US assets. “This leaves the interest-rate argument as the most potent dollar-bear argument, in our view,” Chandler says. There is a reasonable chance with the recent string of constructive US data, which contrasts with weaker-than-expected eurozone data, that short-term interest rate differentials will stabilize and perhaps even widen in the US favor, he says.

As Global Finance went to press in mid-January, the Japanese yen made its biggest increase in nearly two months amid escalating expectations of a rate increase by the Bank of Japan. The yen’s rebound was accompanied by strengthening in the Swiss franc, marking a classic case of unwinding of carry trades, or borrowing in countries with low interest rates, such as Japan and Switzerland, to invest in countries with higher rates.

The current-account surpluses of the countries that have most actively shifted from the dollar, typically oil exporters, are falling fast, while the surpluses of the savings-glut countries locked into the dollar are growing, says Dumas of Lombard Street Research. The portfolio shifts that were alleged to be driving the dollar down are likely to weaken in 2007, he predicts. “The oil exporters may like the euro and [the UK pound] sterling, but their firepower is being reduced,” he notes. With the US economy proving stronger than expected, the dollar’s weakness could go away, he adds.

The structural surplus countries, including China, may well regret having to build up dollar holdings, but they have no choice, Dumas says. Their export-led growth model requires keeping the dollar expensive, he says.


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Gordon Platt

 

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