The Dollar and Emerging Markets - Is the Rally Over?

As the first quarter winds down, the sharp rise in G7 interest rates, especially in the US and Europe, and expectations of future tightening of monetary policy, have undermined equity markets and sparked a violent sell-off in many emerging markets.

There are two key concerns for investors. The first relates to the outlook for the US dollar. Can the dollar resume its rally which seems to have largely stalled out here in Q1 after posting what appear be cyclical highs in Q4 05? The second is about the outlook for emerging markets given the high interest rate environment. Is the rally in emerging markets over or is this just a hiccup as the asset class periodically experiences.

There is little compelling reason to abandon a favorable outlook for the US dollar. The dollar’s resilience to the news this week of a record trade deficit in January suggests that this once favored market explanation for dollar movement is passé.

Yet listening to some pundits, one would get the idea that when the dollar appreciates it is because the market is focusing on cyclical factors and when the dollar falls, the market’s focus is on structural issues. Of course, “structural issues” is a euphemism for the trade deficit. Yet such logic is fallacious. The view of structural issues is far too narrow. Shouldn’t the fact that US productivity growth has outstripped other industrial countries for several years also be considered a structural factor, or that this year will be the 14 of the past 15 years that the US economy grows faster than Europe?

In addition, such an explanation does not appreciate the cyclical forces that weighed on the dollar during the first part of the decade. The fact that the Fed funds rate had been cut to 1% and that the US yield curve was so steep offers a more compelling reason for the dollar’s weakness than the swelling US trade deficit. This is to say that whether it is about the dollar or the stock market in the late 90s, the market tends to under-estimate the power of cyclical influences. These cyclical factors provide a more satisfactory explanation of the dollar movement than a model that suggests market participants inexplicably shift between narrowly defined structural influences and cyclical factors.

One of the key factors that we expect to continue to support the dollar is the widening of interest rate differentials. In particular, we look at the spread between the Euribor and Eurodollar futures contracts. Both contracts are futures on three-month time deposits. The spread between the June Euribor and June Eurodollars appeared to peak last August near 220 basis points. However, the spread widened to new multi-year highs, reaching 225 bp on February 21. Since then the spread narrowed to 214 bp as of last Friday. However, throughout this week the spread has widened out again and as this is written the spread is back at 220 bp.

There is good reason to suspect the spread will widen further. First, one needs to appreciate the fact that the Federal Reserve does not appear to have ever stopped tightening policy when the macro-economic variables were as strong as they are now and as strong as Fed’s central tendency forecasts suggest will continue to be the case:

1. Unemployment below 5%, the economy creating on average 200k+ jobs a month, hourly earnings rising at its fastest past in

5½ years.

2. Real growth is running on a trend basis between 3.0-3.5%, with Q1 05 growth forecasts of around 5%.

3. At 80.5%, manufacturing capacity utilization is at its highest level since 2000.

4. Monetary aggregates, like adjusted monetary base, appear to be accelerating.

5. The spread between the inflation protects securities and the conventional Treasuries has widened by about 20 bp here in Q1 suggesting inflation expectations are rising.

Most market participants now recognize the likelihood that the Federal Reserve will continue to raise rates. The Fed funds futures market shows an increasing perception that the FOMC will not pause in H1. The July Fed funds futures contract, a reasonably good gauge for expectations of Fed policy in H1, now implies something above 5%.

For the first time, in the current monetary cycle, the market may be getting a bit ahead of itself. Data in the coming days, like retail sales, may indicate that the strength in January probably over-stated the case. In addition, judging from some anecdotal data, the market may also be disappointed with the Treasury’s TIC data and housing data. Just like Q4 05 under-stated the strength of the US economy, Q1 06 GDP is likely to over-state it and the strength appears to have been front loaded into the early part of the quarter.

This suggests that the dollar is likely to remain range-bound in the period ahead. Given that the greenback is trading on the strong side of its recent range, it means the risk is for some near-term weakness. Specifically, the euro traded as low as $1.1827-30 in late February. This represents the lower end of its range. Stops should be placed under there to allow a marginal new low. On the upside, initial resistance is seen in the $1.1930-50 area and but in a corrective fashion, the euro could re-challenge the $1.20 area.

Although there was some anxiety earlier, it has become clear that Japan will retain its zero-interest rate policy for several more months. The BOJ’s plan to reduce the current account surplus provided to the banks may be best understood as a technical adjustment. The fact of the matter is that Japanese banks were not able to use the full JPY30-35 trillion that the BOJ was making available. Therefore gradually withdrawing is not the earth-shattering development that many had feared. This means that the yen will retain its role as a financing currency. The yen has actually weakened since the BOJ announced it would abandon the quantitative easing policy. The dollar’s high for the year against the yen was set in early Feb near JPY119.40. The greenback nosed above JPY119 after the US employment data. There is scope for additional minor gains, but the yen’s weakness is likely to be more pronounced on the crosses that against the dollar. Moreover, next week the Swiss National Bank is widely expected to raise rates, rather than simply talk about as the BOJ, and this may encourage shifting back to yen carry trades from Swiss franc carry trades.

This is a nice segue into the emerging markets. With the global economy growing at a healthy clip and liquidity conditions still ample and many emerging markets enjoying improved fundamentals (debt dynamics, external balances, healthy growth), quest for returns and diversification will likely keep many international fund managers in the emerging markets, even if more selectively. The sell-off in emerging markets seemed to have largely run its course in the first half of the week and a more stable tone, with even upticks seen at the end of the week. East Asian seemed to stabilize first, helped by strong domestic economies and their largest trading partners—US, China, and Japan. Latin American investments are more vulnerable to the setback in commodity prices and the backing up of US and European interest rates, but the markets there too appear to be finding better footing.

Eastern and Central European countries have some internal challenges, but the bourses are also stabilizing. Global asset managers may have front-loaded their asset allocation to the emerging markets earlier in the quarter. Outright selling by international investors seems rather modest. Rather than sell, they just don’t appear to be buying. This may change at the start of the new calendar quarter and the start of a new fiscal year in Japan.