Forces that Reflate

Over the past several weeks the US dollar has been largely confined to well worn ranges against the major foreign currencies. The equilibrium implied by range trading environment might be giving investors a false sense of security. There are a number of developments in other markets that warn that the calm in the foreign exchange market might not last much longer. Specifically there have been significant declines in commodity prices, interest rates and premium offered by the US over the euro-zone.

Since early August, the basket of commodities tracked by the RJ/CRB Commodity Price Index has fallen 14%. Crude oil prices are off 19%, while natural gas has tumbled more than 35%. Indeed over the past three weeks, the CRB Index of 19 commodities has recorded its largest decline in a quarter of a century. For the first time since late March, the price of crude oil is below the 100 and 200 day moving averages. The decline in crude is already fueling a decline in gasoline prices and the pump. This should help support US household consumption and help blunt the negative impact associated with the weakness in house prices. In the period ahead, many economists are likely to revise up their forecasts for US GDP, it not for Q3 than Q4. It has thus far not has not had knock on effects on expectations for the trajectory of Fed policy, but this remains a distinct risk.

The dollar-bloc currencies, the Australian, New Zealand, and Canadian dollars, are thought to be particularly sensitive to commodity prices. However, the recent price action illustrates the difficulty in trading these currencies as proxies for commodities. As commodity prices fell in August, the Australian dollar traded broadly sideways mostly confined to a $0.77-handle. The Australian dollar has decline about a cent so far here in the first half of September. In contrast, the New Zealand dollar continued the trend higher than began in July. During the month of August the kiwi rose from about $0.6200 to almost $0.6700. It did sell-off in early September, but has soared this week to reach its highest level since early March on the back of hawkish comments from the central bank that seemed to raise the possibility of a rate hike early next year. For its part, the Canadian dollar gained ground throughout August and but has sported a softer profile here in September.

A number of emerging market and developing countries are also thought vulnerable to falling commodity prices. The South African rand, for example, has been tending lower since mid-August and has approached the lows recorded in the May-June swoon in emerging markets. The Brazilian real continued its recovery from its May slide, rising to its best levels since mid-May at the start of September. Even the Chilean peso, which is perceived to be sensitive to copper prices—which are only now slipping below the 100-day moving average—is trading firmer than it ended July.

Along side the fall in commodity prices, US bond yields have fallen nearly 50 bp since peaking in mid-summer. Some very preliminary indications suggest that the lower rates are beginning to help support the housing market. The lower term structure also means that fears that a multitude of US would be significantly pinched as adjustable rate mortgages adjusted may be exaggerated. There is some anecdotal evidence that suggests many might be rolling into new ARMs which also helps minimize or postpone the interest rate adjustment.

The decline in interest rates is not limited to the US. And the decline in global interest rates may help bolster the world economy. European 10-year bond yields have fallen 20 bp over the past three months and 10-year Japanese government bonds yields have fallen 13 bp. It is true that these are not large moves, but the direction is important. On the margins the headwind of higher long term interest rates has subsided.

Many observers fear that the global economy was headed was a hard landing, spurred by higher interest rates, higher energy prices and the demise of the US consumer under the weight of a collapsing housing market bubble seem exaggerated. As recently as yesterday, September 14, the IMF was warning that the strongest global economic expansion in 30-years may be at risk because of high energy costs and a drop in US prices. These views seem dated and rather than a hard landing, the risk would seem to lie in the other direction: that the decline in interest rates and commodity prices prevents the kind of economic slowdown the Federal Reserve is anticipating would relieve pressures on capacity constraints and prices.

With the Fed funds futures strip still implying the US monetary tightening cycle has peaked, many investors still ill-prepared for a reflation of the US economy. While it is clear that the Federal Reserve will stand pat next week and the bar seems high for an October move, we still see the risk of further monetary tightening. However, the dollar may not derive much lasting support from a future Fed hike, if one materializes, because it would be seen as reacting to developments rather than anticipating them. This is to say, although the consensus is strongly in favor of a steady Fed policy in the months ahead, many will suspect the Fed was slipping behind a curve.

That brings us to the other key trend that unfolded while the dollar has been confined to well-defined trading ranges. Namely the premium the US offers over the euro-zone has trended lower since mid-June. Then the spread between the December Euribor futures contract and the December Eurodollar futures contract stood at 214 bp. Earlier this week it was testing 167 bp. The spread on the June 07 contracts narrowed to 125 bp in the middle of this week. The current three month LIBOR (London Interbank Offered Rate) spread stands near 210 bp.

The market is confident that the European Central Bank will hike its key rate another 25 bp in early October and most likely again in early December. Moreover, over the last couple of weeks, top ECB officials have been trying to disabuse the market of the notion that it will finish its monetary tightening this year. Many observers had thought that with the VAT set to rise 3 percentage points in Germany next year and tighter fiscal policies in other countries as well, the ECB would want to finish the rate hikes sooner rather than later. From the ECB’s point of view the upside risks to inflation remains strong, with money growth well above desired and real interest rates still historically low. This suggests that even if the Federal Reserve were to raise rates again, the trend of short-term interest rate differentials may continue to work against the dollar.

The near-term outlook for the euro-dollar is not immediately clear, even though in the medium and longer terms, we expect the dollar to move lower. Near-term technical indicators warn of additional scope for dollar gains. First, there appears to be a possible head and shoulders technical pattern in the euro, essentially traced out in August and early September. As long as the euro remains below the $1.2750 high set on Sept 14, with the 100-day moving average coming in near $1.2735, the risk is for is on the downside, with a minimum objective of about $1.2550. Recall that the June and July lows were recorded in the $1.2450-80 area. The 200 day moving average, which the euro has not traded below since March comes in near $1.24. On the other hand, although the lower end of the euro’s recent narrow trading range has been frayed. Watch sterling, which appears to often leads the euro against the dollar. A break of the $1.8725 area would likely signal not only additional losses for sterling , but would also likely signal additional near-term euro losses.