I believe that the recent rhetoric by US officials – both Treasury Secretary Paulson and Fed Chairman Bernanke – is important, not just for the dollar against other G10 currencies, but also possibly for oil and some other commodity prices. Additionally, if commodity/oil prices are indeed capped by a falling EUR/USD, the USD’s rally could be much more broad-based than many may realise. Could the ECB’s 10th anniversary mark the peak in the EUR?
Some Thoughts on Recent US Comments on the USD
My colleagues (Sophia Drossos, Dick Berner and David Greenlaw) have all commented on Fed Chairman Bernanke’s explicit reference to the dollar in his speech on June 3, 2008. Here are some thoughts I have to add to this discussion:
1. Chairman Bernanke emphasised the costs of a weak dollar rather than its benefits; this is a dramatic shift in Fed policy. Throughout the rate cut cycle, the Fed, not just the chairman, has consistently highlighted net exports as being the only bright spot in the economy. While I believe that much of this outperformance in exports was due to strong external demand, just as German and Japanese exports have also remained strong, despite strong currencies, many Fed officials have credited the role of the weak USD, without proof – an opinion I have never found convincing. In any case, in this speech, Chairman Bernanke shifted the focus from the benefits of a weak USD (strong exports) to the costs of a weak dollar (high imported inflation and rising commodity prices). At a minimum, this implies that the Fed has no intention of cutting the FFR below 2.00% – consistent with the view of our US economists. Firming up the floor in the FFR should, all else equal, be positive for the dollar.
2. Secretary Paulson’s visit to the Middle East last weekend was a dollar-positive event. Chairman Bernanke’s comments on the USD should be seen in conjunction with Treasury Secretary Paulson’s visit to the GCC countries (Saudi Arabia, the UAE and Qatar). Secretary Paulson extracted an unconditional endorsement from Saudi Arabia and a conditional one from the UAE for the dollar pegs. Secretary Paulson said that this is a “sovereign decision”, stressing that the US Treasury would not pressure the GCC one way or another on the pegs. But this, from one perspective, is inconsistent with the US Treasury’s policy toward China’s currency regime. The Treasury’s stance toward China was far from ‘benign neglect’, in my view. Incidentally, the collective C/A surplus of the GCC (above US$500 billion) is on track to exceed China’s this year. Also, at current oil prices, the GCC could have a collective C/A surplus as large as 80% of the US C/A deficit, which continues to shrink. For the US to have such a soft stance on the GCC, despite their large C/A deficit, there might be a USD objective. (Having said this, it’s important to note that the GCC are much smaller in size (population and economy) than China. Currency movements could in theory induce ‘expenditure switching’ as the country with the strengthening currency effectively switches from exports to imports. But with the GCC economies so small, no matter how much their currencies strengthen, it would be virtually impossible to eliminate their C/A surplus. China is different, at least in theory.)
3. Joint interventions may not be necessary to engineer a turn in the USD. I have made the point that, since the breaking up of the Bretton Woods System in 1973, without exception, every turning point after multi-year moves in the major USD index has been accompanied by coordinated interventions. Thus, for the USD to turn, I have, for a while, been looking for outright joint interventions. While this may still happen, there is also the possibility that the world has changed and the FX markets are now so big (US$3.1 trillion in daily turnovers) that coordinated interventions may no longer work, and verbal interventions and other means, such as what Secretary Paulson achieved in the Middle East, may be more effective. The point here is that the G2 may be trying to engineer a turn in the USD without a joint intervention.
4. The Fed and the ECB remain key for future movements in EUR/USD. While the market has responded to the recent rhetoric from US officials, the decline in EUR/USD has been relatively modest, and it remains in a range of 1.52-1.60 since late February. Whether the dollar appreciates further, in my view, depends to a large extent on the evolution of the policy rates in the G10. I think that the Fed cannot ease further if the dollar is now a concern. Further dollar appreciation requires (i) a slowdown in Euroland and/or (ii) a recovery in the US that will make it possible for the Fed to contemplate rate hikes. At the ECB’s press conference earlier today, President Trichet’s tone was hawkish. We have had round-table discussions in the past couple of weeks. When the possibility of further ECB rate hikes was raised, it was summarily rejected by every client at these roundtables. I am not as confident as our investors and believe that an ECB rate hike cannot be completely ruled out. The key point here is that verbal interventions can augment and accentuate currency movements that are consistent with the underlying monetary and economic paths, but not reverse them.
5. Other considerations favour the dollar, even in the absence of the recent US rhetoric. Before this round of verbal intervention, we already had the view that the USD should eventually reassert itself. Regular readers should know our basic argument. But just as an update, the US C/A deficit continues to shrink and could reach 4.5% of GDP by year-end, down from 6.7% in 4Q05. At the same time, the USD is very undervalued. EUR/USD’s median fair value, according to our valuation framework, is 1.24.
Impact on Oil and Other Commodity Prices
The direct impact of the latest round of verbal interventions on the USD may be well-recognised. However, I believe that the more important implication is that a determined USD rally could cap the rise in crude oil. As we have argued in the past, the dollar’s weakness has helped to propel oil prices higher, through both the numeraire effect and speculative activities. In turn, high dollar prices of oil conveyed the impression that inflation is higher than it was, and much of the rest of the world has reacted with a more hawkish monetary stance. The resulting yield differential further depressed the dollar, setting off another round of this vicious circle. I believe that the dollar has grossly undershot, and suspect that oil has overshot. If the bottom in the USD indeed coincided with the top in oil and other commodity prices, then all the commodity-exporting currencies should suffer. In earlier notes (see DEFCON-3 on Some Emerging Market Currencies, May 15, 2008 and Four Fall-Lines of Dominos: An Ordinal Ranking, May 1, 2008), we ranked currencies according to the net trade position in commodities. On this measure, CLP, NOK, AUD, NZD, ZAR, TRY and ARS look vulnerable. Clearly, a stabilisation or a correction in general commodity prices would have much broader implications beyond the currency markets.
AXJ Currencies Are Vulnerable
I still believe that the risks to USD/AXJ are biased to the upside. For much of the past two years, AXJ currencies rallied against the dollar, propelled by strong economic fundamentals. However, I suspect that, in coming months, AXJ currencies will have a much more difficult time against the dollar. In Dollar Smirks in Asia (May 1, 2008), I argued that, when pressed, Asia would always choose to protect growth rather than stabilise inflation. The stagflationary conditions would be particularly challenging for the AXJ and other EM policymakers.
First, inflation targeting, as a regime, will be stress-tested and many EM central banks will not pass this test. Inflation targeting (IT) has attained a ‘politically correct’ status. Other models of monetary policies – including the dual mandate framework of the Fed – are considered unorthodox, and the general view is that it will be only a matter of time until most central banks adopt IT. I remain skeptical, and believe that IT will be severely stress-tested in the period ahead, and the first breakage will occur in EM. Many EM economies have 30-50% of their CPI weights in food and energy. If most of the inflationary pressures in these categories are global in nature, it would not be credible if EM central banks were to tell the world that they will drive the non-food non-energy sectors into a recession just to offset international inflation in commodities? As I have argued in the past, when pushed, AXJ and many other EM economies will almost always choose to protect growth rather than inflation. This could either mean that the policymakers no longer welcome currency appreciation, and/or the monetary authorities have a ‘moratorium’ on IT, just as the ECB has looked the other way on its M3 growth target. This ‘forgive-but-not-forget’ stance on the M3 growth target would jeopardize EM central banks’ credibility. I don’t believe that their currencies will be rewarded.
Second, the partial and gradual removal of energy and food subsidies will lead to more persistent stagflationary pressures in the EM economies, but would be ‘Goldilocksy’ for the developed economies. We first made this point in Enjoy the Energy Subsidies While You Can (May 22, 2008). This process also shifts the balance in favour of the developed currencies and against the EM currencies.
Third, a generalised recovery in the USD against the majors, as discussed above, will likely spill over to also affect the likes of USD/CNY and USD/SGD and, in turn, the rest of USD/AXJ.
Some AXJ currencies will rally on some days and weaken on others in the near future. My point is that the structural downtrend in USD/AXJ will be interrupted in the coming weeks. With the negative carry in most cases, such positions are no longer interesting.
Bottom Line
Verbal interventions by Secretary Paulson and Chairman Bernanke have direct implications for the dollar, but also indirect – and possibly more powerful – USD implications through commodity prices. We continue to believe that the USD will reassert itself, but the process will be hesitant and asynchronous against different currencies. But the latest developments suggest that such a USD recovery could become more broad-based, as some commodity exporters’ currencies and AXJ currencies are becoming vulnerable against the dollar.
Some Thoughts on Recent US Comments on the USD
My colleagues (Sophia Drossos, Dick Berner and David Greenlaw) have all commented on Fed Chairman Bernanke’s explicit reference to the dollar in his speech on June 3, 2008. Here are some thoughts I have to add to this discussion:
1. Chairman Bernanke emphasised the costs of a weak dollar rather than its benefits; this is a dramatic shift in Fed policy. Throughout the rate cut cycle, the Fed, not just the chairman, has consistently highlighted net exports as being the only bright spot in the economy. While I believe that much of this outperformance in exports was due to strong external demand, just as German and Japanese exports have also remained strong, despite strong currencies, many Fed officials have credited the role of the weak USD, without proof – an opinion I have never found convincing. In any case, in this speech, Chairman Bernanke shifted the focus from the benefits of a weak USD (strong exports) to the costs of a weak dollar (high imported inflation and rising commodity prices). At a minimum, this implies that the Fed has no intention of cutting the FFR below 2.00% – consistent with the view of our US economists. Firming up the floor in the FFR should, all else equal, be positive for the dollar.
2. Secretary Paulson’s visit to the Middle East last weekend was a dollar-positive event. Chairman Bernanke’s comments on the USD should be seen in conjunction with Treasury Secretary Paulson’s visit to the GCC countries (Saudi Arabia, the UAE and Qatar). Secretary Paulson extracted an unconditional endorsement from Saudi Arabia and a conditional one from the UAE for the dollar pegs. Secretary Paulson said that this is a “sovereign decision”, stressing that the US Treasury would not pressure the GCC one way or another on the pegs. But this, from one perspective, is inconsistent with the US Treasury’s policy toward China’s currency regime. The Treasury’s stance toward China was far from ‘benign neglect’, in my view. Incidentally, the collective C/A surplus of the GCC (above US$500 billion) is on track to exceed China’s this year. Also, at current oil prices, the GCC could have a collective C/A surplus as large as 80% of the US C/A deficit, which continues to shrink. For the US to have such a soft stance on the GCC, despite their large C/A deficit, there might be a USD objective. (Having said this, it’s important to note that the GCC are much smaller in size (population and economy) than China. Currency movements could in theory induce ‘expenditure switching’ as the country with the strengthening currency effectively switches from exports to imports. But with the GCC economies so small, no matter how much their currencies strengthen, it would be virtually impossible to eliminate their C/A surplus. China is different, at least in theory.)
3. Joint interventions may not be necessary to engineer a turn in the USD. I have made the point that, since the breaking up of the Bretton Woods System in 1973, without exception, every turning point after multi-year moves in the major USD index has been accompanied by coordinated interventions. Thus, for the USD to turn, I have, for a while, been looking for outright joint interventions. While this may still happen, there is also the possibility that the world has changed and the FX markets are now so big (US$3.1 trillion in daily turnovers) that coordinated interventions may no longer work, and verbal interventions and other means, such as what Secretary Paulson achieved in the Middle East, may be more effective. The point here is that the G2 may be trying to engineer a turn in the USD without a joint intervention.
4. The Fed and the ECB remain key for future movements in EUR/USD. While the market has responded to the recent rhetoric from US officials, the decline in EUR/USD has been relatively modest, and it remains in a range of 1.52-1.60 since late February. Whether the dollar appreciates further, in my view, depends to a large extent on the evolution of the policy rates in the G10. I think that the Fed cannot ease further if the dollar is now a concern. Further dollar appreciation requires (i) a slowdown in Euroland and/or (ii) a recovery in the US that will make it possible for the Fed to contemplate rate hikes. At the ECB’s press conference earlier today, President Trichet’s tone was hawkish. We have had round-table discussions in the past couple of weeks. When the possibility of further ECB rate hikes was raised, it was summarily rejected by every client at these roundtables. I am not as confident as our investors and believe that an ECB rate hike cannot be completely ruled out. The key point here is that verbal interventions can augment and accentuate currency movements that are consistent with the underlying monetary and economic paths, but not reverse them.
5. Other considerations favour the dollar, even in the absence of the recent US rhetoric. Before this round of verbal intervention, we already had the view that the USD should eventually reassert itself. Regular readers should know our basic argument. But just as an update, the US C/A deficit continues to shrink and could reach 4.5% of GDP by year-end, down from 6.7% in 4Q05. At the same time, the USD is very undervalued. EUR/USD’s median fair value, according to our valuation framework, is 1.24.
Impact on Oil and Other Commodity Prices
The direct impact of the latest round of verbal interventions on the USD may be well-recognised. However, I believe that the more important implication is that a determined USD rally could cap the rise in crude oil. As we have argued in the past, the dollar’s weakness has helped to propel oil prices higher, through both the numeraire effect and speculative activities. In turn, high dollar prices of oil conveyed the impression that inflation is higher than it was, and much of the rest of the world has reacted with a more hawkish monetary stance. The resulting yield differential further depressed the dollar, setting off another round of this vicious circle. I believe that the dollar has grossly undershot, and suspect that oil has overshot. If the bottom in the USD indeed coincided with the top in oil and other commodity prices, then all the commodity-exporting currencies should suffer. In earlier notes (see DEFCON-3 on Some Emerging Market Currencies, May 15, 2008 and Four Fall-Lines of Dominos: An Ordinal Ranking, May 1, 2008), we ranked currencies according to the net trade position in commodities. On this measure, CLP, NOK, AUD, NZD, ZAR, TRY and ARS look vulnerable. Clearly, a stabilisation or a correction in general commodity prices would have much broader implications beyond the currency markets.
AXJ Currencies Are Vulnerable
I still believe that the risks to USD/AXJ are biased to the upside. For much of the past two years, AXJ currencies rallied against the dollar, propelled by strong economic fundamentals. However, I suspect that, in coming months, AXJ currencies will have a much more difficult time against the dollar. In Dollar Smirks in Asia (May 1, 2008), I argued that, when pressed, Asia would always choose to protect growth rather than stabilise inflation. The stagflationary conditions would be particularly challenging for the AXJ and other EM policymakers.
First, inflation targeting, as a regime, will be stress-tested and many EM central banks will not pass this test. Inflation targeting (IT) has attained a ‘politically correct’ status. Other models of monetary policies – including the dual mandate framework of the Fed – are considered unorthodox, and the general view is that it will be only a matter of time until most central banks adopt IT. I remain skeptical, and believe that IT will be severely stress-tested in the period ahead, and the first breakage will occur in EM. Many EM economies have 30-50% of their CPI weights in food and energy. If most of the inflationary pressures in these categories are global in nature, it would not be credible if EM central banks were to tell the world that they will drive the non-food non-energy sectors into a recession just to offset international inflation in commodities? As I have argued in the past, when pushed, AXJ and many other EM economies will almost always choose to protect growth rather than inflation. This could either mean that the policymakers no longer welcome currency appreciation, and/or the monetary authorities have a ‘moratorium’ on IT, just as the ECB has looked the other way on its M3 growth target. This ‘forgive-but-not-forget’ stance on the M3 growth target would jeopardize EM central banks’ credibility. I don’t believe that their currencies will be rewarded.
Second, the partial and gradual removal of energy and food subsidies will lead to more persistent stagflationary pressures in the EM economies, but would be ‘Goldilocksy’ for the developed economies. We first made this point in Enjoy the Energy Subsidies While You Can (May 22, 2008). This process also shifts the balance in favour of the developed currencies and against the EM currencies.
Third, a generalised recovery in the USD against the majors, as discussed above, will likely spill over to also affect the likes of USD/CNY and USD/SGD and, in turn, the rest of USD/AXJ.
Some AXJ currencies will rally on some days and weaken on others in the near future. My point is that the structural downtrend in USD/AXJ will be interrupted in the coming weeks. With the negative carry in most cases, such positions are no longer interesting.
Bottom Line
Verbal interventions by Secretary Paulson and Chairman Bernanke have direct implications for the dollar, but also indirect – and possibly more powerful – USD implications through commodity prices. We continue to believe that the USD will reassert itself, but the process will be hesitant and asynchronous against different currencies. But the latest developments suggest that such a USD recovery could become more broad-based, as some commodity exporters’ currencies and AXJ currencies are becoming vulnerable against the dollar.
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