The Bull Case for the Dollar

The disappointing Q4 2005 US GDP report and the subsequent dollar decline is unlikely to have a lasting impact on the market. In fact, there are good reasons to expect the US dollar to strengthen in the days ahead.

The 1.1% pace of growth in Q4 2005 was the slowest since Q1 03 and breaks the string of 10 consecutive quarters of 3%+ growth. Nevertheless, early indications suggest the US economy has likely rebounded and when considering the outlook for the Federal Reserve and the dollar, this outlook is more important that the Q4 disappointment.

There will be three main developments next week in the US and each should be dollar friendly. First, on Tuesday the Federal Reserve will hike the Fed funds target 25 bp to 4.5%. As it well appreciated, Fed officials use the news media to signal the market, i.e., help guide expectations. A couple of such Fed-watchers have opined recently that the statement that accompanies the rate decision is likely to keep the door open to further rate hikes, which is consistent with our view that while the Fed’s work is nearly done, there are a few more hikes likely, with the funds rate peaking 5.0-5.25%.

Market participants appear to have upgraded their assessment of the risk of a March hike. As recently as Jan17-18, the market was roughly evenly divided between those expecting a March hike and those thinking “one-and-done”. However, more recently the pendulum of market sentiment has swung toward the March hike. The odds rose from a little more than 50% to more than 75% and retreated to about 66% after the disappointing GDP data. If next week’s data is as strong as the consensus currently expects, the market is likely to upgrade the odds of a March hike.

Second, although it might have been lost in the preliminary quarterly data, momentum in the US economy likely improved at the end of 2005. Recall that the ISM data was revised showing a larger gain in December (55.6 from 54.2), while the Oct and Nov data were revised lower. The strength of the Philly and Richmond Fed surveys and the Empire State survey suggest the January manufacturing ISM should be firm, confirming continued strength in the manufacturing sector, which appears to be picking up some slack from the slowing of the housing market. This also touches on the issue raised by the Fed last month about resource utilization rates.

Third, the US reports January jobs data on Friday, February 3. The preliminary estimate is for a robust 240k following the disappointing 108k increase in December. Although the fit is imperfect to be sure, the weekly initial jobless claims stand near their lowest level in five years, suggesting some improvement in the labor market. IIf, and admittedly this is a big “if” this turns out to be a fairly accurate forecast, the 3-month average would move above 200k to sit at its best level since last April. Such a strong report would also likely be dollar friendly and reinforce ideas that the economy is growing sufficiently robust as to continue to absorb what ever slack remains in the economy and would seem to underscore the likelihood of additional Fed tightening.

In addition to the data pipeline, another dollar-positive development has been interest rate differentials. The spread between the June Euribor and the June Eurodollar futures contract has gradually widened in recent days and has resurfaced above 200 bp. On Jan 3 the spread stood at about 188 bp. Of course, a 12 bp shift is nothing to get excited about, but the direction is important and it is still not clear that the short-term interest rate differentials have peaked in the cycle. The high of the spread thus far was set in the middle of last August near 220 basis points.

The 10-year spread between the US Treasuries and German bunds (a useful proxy for the euro-zone) has also widened in recent sessions. The spread put in a recent high in last October 2005 near 123 bp, after finishing 2004 near 55 bp. However, the spread narrowed to about 95 bp in late November. As recently as Monday January 23, the spread stood at 97.4 and is now back above 102 bp. Again the magnitude of the move is more important than the magnitude.

There are also a number of technical indications that the dollar may come back into favor after beginning the year heavily. Looking at the euro, it is interesting to note that the magnitude of the bounce off the late Nov 05 lows has been very much in line with the size of euro corrections seen during last year’s dollar bull run. In addition, the MACD (moving average convergence divergence is crossing to the downside for the euro from its highest level since last August. Just as importantly is the fact that the euro had moved above its 200-day moving average on January 23 for the first time since last spring and although it spent a few days above there, it was rebuffed despite the soft US GDP data. The euro spent most of the past month in the $1.2000-$1.2200 trading range. The breakout to the upside proved premature and now we should anticipate a test on the lower end of that old range.