Dollar Bulls Still in Driver's Seat

After stalling near midweek, the U.S. dollar’s upside momentum has been rekindled. The greenback’s gains are especially impressive because they have been scored in the wake of disappointment on two of the most market-sensitive reports: U.S. employment and trade balance. Moreover, these gains are being registered at the same time that interest rate differentials with the euro-zone have actually narrowed. At the short-end the December Eurodollar futures contract is off 7 ticks over the past three weeks. The December Euribor futures contract has shed 15 ticks in the same time. U.S. 10-year yields have risen 17 basis points in the past month, while the yield on 10-year bunds has risen 32 basis points.

The dollar’s ability to resurface above the JPY118 level is also impressive. Stronger than expected Q3 Japanese GDP (1.7% at a seasonally adjusted annual rate compared with consensus forecasts for a 1.1% increase) and new multi-year highs for the Nikkei. Key resistance is still seen near JPY118.40.Beyond there, the next main objective is near JPY120.

Meanwhile, BOJ Governor Fukui seems to be continuing to prepare the market for an end to theextraordinary monetary policy, even though government officials have somewhat diluted the message bypublicly arguing in favor of patience. The overall GDP deflator fell 1.1% after a 0.9% fall in Q2. However, given that the domestic deflator was unchanged at -0.3%, ironically the slightly stronger deflationary pressures were being imported.

Comments by the MOF’s Watanabe on November 10th also illustrate why the speculative market feels comfortable with a substantial short yen position. Watanabe was quoted on the news wires suggesting that with the dollar near JPY117, the yen was not weak. He seemed to rule out intervention. In turn, this indicates the Watanabe, and by extension Japanese officials, are focusing on the nominal level of the yen. Its real value has not seen these low levels since late summer 1998. Recall in the spring of that year, Japan, which on at least one occasion was joined by the US Treasury (led at the time by Robert “Strong Dollar is in US interest Rubin) intervened to sell US dollars and buy yen.

The market has largely shrugged off new hawkish rhetoric by the ECB’s Liebascher. He argued for the advantages of preventative measures over reactive. While this sounds reasonable, the difficulty in operationalizing is that it assumes there is something to prevent, even though no ECB official has made the argument that there are already signs of second-round impacts from the higher energy prices.

Euro resistance is seen initially near $1.1720, but a move above the $1.1820-50 area is needed to begin repairing the technical damage inflicted this week. On the downside, there is increasing talk of a $1.1600 near-term objective, with some reports indicating interest in 1-week options struck near there. Sterling is struggling to stabilize. Initial support is seen near $1.7360-80. A break would signal a test on the year’s low set in July near $1.7275.

After being harassed in Latin America and seeing what he indicated as the centerpiece of his hemispheric strategy, a free-trade agreement for the Americas, defeated, President Bush is off to Asia next week. China is in his sights. It reported a record monthly trade surplus of $12 billion for September a day before the U.S. reported a record monthly trade deficit of $66.1 billion.

Ahead of his trip 15 Senators wrote the President a letter urging a tougher line on both China and Japan. The Big Three auto makers have also recently complained about China and Japan’s “currency market manipulation”. The case against Japan seems particularly weak as the BOJ has not intervened in the currency markets for more than a year and a half (not since March 2004). The dollar’s rise to 2-year highs against the yen is not a function of Japan’s currency policy. A more compelling explanation are interest rate differentials. Japanese investor demand for foreign bonds and speculators use of the yen as a financing currency are the main forces weighing on the yen.

This illustrates an important point about the currency markets that not generally understood. The currency value that would help bring the trade accounts to more sustainable levels may not be the same value that clears the capital market. It is not clear that the conventional emphasis on the currency level needed for the trade account is justified a priori.

Also, what officials miss, but many market participants recognize, is that BOJ intervention was not very effective. The dollar generally slid as the BOJ intervened aggressively between September 2003 and March 2004. More than $200 billion were bought in that six month period, but the dollar fell from JPY116- 118 in September 2003 to about JPY103.5 at the end of March 2004.

The Chinese story is more complicated. A stronger case can be made that the Chinese are purposely keeping its currency under-valued by most economic measures. A Chinese government report forecasts its trade surplus will rise next year to $117 billion from $100 billion this year. It expects its currency reserves to rise to $950 billion next year from about $770 billion in September.

The fact that reserve growth is again expected to be larger than its trade surplus suggests that China’s reserve growth is more than simply recycling its trade surplus. It is also is trying to re-cycle part of the hot money inflows and foreign direct investment entering the country.Not only is Japan’s intervention not very effective and China’s intervention aimed at something larger than simply boosting exports, the U.S. emphasis on currencies is misplaced because the key to U.S. exports is not so much price but demand. It is almost as if the US is trying to replicate its policy in getting Japan to accept currency appreciation with China. It is confused. While the dollar has fallen from more above JPY250 in 1980, the bilateral trade deficit has swelled from about $10 billion in 1980 to around $80 billion over the past 12-months.

Let's hope we don't enjoy that "success" again.