Dollar Resilience Still Impressive

The U.S. dollar’s resilience is impressive. The head of the European Central Bank gave the clearest signal to date that he plans on raising rates on December 1st and the market could not even keep the greenback down for an hour.

The firmness of the dollar is all the more noteworthy because it is taking place most recently as interest rate differentials move against it. Since the end of October, the interest rate implied by the March Eurodollar futures contract has increased by 5 basis points, while the yield implied by the comparable euro contract has risen by 21 basis points.

The shift of interest rate differentials is not simply a short-end phenomenon, but it is evident in the bond market as well. Over the past month, the yield on the 10-year U.S. Treasury bond has risen 2 basis points while the 10-year German bund yield has risen 24 basis points.

The dollar’s strength in such an interest rate an environment may seem counter-intuitive. After all, many observers have barely shifted from a current account driven explanation of the dollar’s weakness to a interest-rate driven explanation of the dollar’s strength. And yet here we are with the dollar still well supported despite the shift in interest rates.

The take away message is that whatever the relationship between the dollar and interest rates may be, it is not linear. The U.S. dollar did not begin rallying in June 2004, when the Federal Reserve began raising interest rates. Indeed, there was a six month lag between the Fed’s first increase and when the U.S. dollar began finding traction. In past bull cycles, the dollar’s advance would continue for some time after interest rate differentials began shifting away from it.

And it is not clear at the moment that interest rate differentials have really peaked or whether the narrowing that has taken place is technical in nature, i.e. a short-term counter-trend development rather than a trend reversal.

Recent economic data has prompted many economists to now look for an upward revision to Q3 GDP and have increased their forecasts for Q4 GDP. At the same time, the market is confident that the Federal Reserve will continue to ratchet higher the Fed funds rate in the coming months. Still the risk is that the market has not fully discounted the extent to which the Fed will likely take the funds rate to next year.

Even augmenting the analysis of the Fed funds futures strip with an examination of the Eurodollar futures strip, the market has not discounted more than a 4.75% Fed funds rate in this cycle. This implies that the Bernanke Fed only raises rates once. Throughout this cycle, market has consistently under-estimated the extent and duration of Fed tightening and this pattern does not appear have been broken.

Nearly all measures of inflation and inflation expectations show price pressures. More businesses appear to be enjoying some pricing power and that could very well be the next part of the inflation story—upward pressure on core (excluding food and energy) prices. The costs for transportation and lodging, for example, are likely to rise as will packaging costs.

Slack in the labor market has been absorbed and job growth is likely to have accelerated in November after the disappointing, but distorted October jobs report. At the same time, productivity has slowed. Don’t be surprised if some economists dusted off their NAIRU models (Non-Accelerating Inflation Rate of Unemployment), especially given Bernanke’s sympathetic stance toward adopting a formal inflation target.

It might be a bit of an exaggeration to say the U.S. economy is firing on all cylinders, but it almost is. The main exception, however, may be a healthy development--the slowing of the housing market. Although there have been earlier signs that the U.S. market is cooling, such as the under-performance of home builder equity prices, the recent data have shown cracks are deepening. A survey conducted by the National Association of Home Builders found the lowest confidence among their members in 18 months.

October housing starts fell 5.6% and are now off 2.3% from year ago levels. The more forward looking housing permits fell 6.7% in October, the largest drop in six years. The average rate of 30-year fixed-rate mortgages have risen about 75 basis points since the summer and appears to have begun taking a toll.

Yet even with the slowing of the housing market, the U.S. economy will continue to be among the strongest in the G7 and will most likely continue to grow around trend—say 3.5%. The U.S. economy expanded by more than 3% for the past 10 quarters and is likely to do so for the next 5 quarters.

Dollar pullbacks have been brief and shallow. This general pattern is also likely to continue. However, in the week ahead, without much in the way of important data releases, the greenback is likely to churn within well-established ranges. Asian sovereigns can be expected to continue to support the euro at the lower end of its recent range around $1.1640-60. On the top side, there seems to be strong offers around the $1.1800 level.

Foreign investors have bought a whopping $76.6 billion worth of Japanese shares this year and more than half has been bought since August. While this foreign buying has helped lift the Nikkei to 5-year highs, it has not helped the yen very much. On the contrary, the dollar is trading near its best levels against the yen since mid-2003 and does not appear to have put in a top yet. Still in the days ahead it may prove difficult for the dollar to rise through the JPY120 psychological level.