Look out Below: Dollar Losses Accelerating

To be forewarned is to be forearmed: Risks are mounting that the US dollar’s slide accelerates into the end of the year. While the $1.4570 area, the euro equivalent of the old Deutschemark record high from 1995, is the obvious near-term objective, the combination of market sentiment and deteriorating interest rate support for the dollar, warns of risk toward $1.50.

The weakness of the US dollar is the overriding feature in the foreign exchange market. It is deterring the market from re-establishing in a significant way yen or Swiss franc carry-trades. Instead, it appears the US dollar is the financing currency of choice. The dollar can fall against the yen toward JPY110.

Even though the Bank of England may be the next major central bank to follow the Federal Reserve’s lead in cutting rates, the dollar weakness will conceal the cracks in sterling. These cracks though should be more evident on the crosses. In this environment, the euro could rise back into the GBP0.7100-GBP0.7200 area.

The acceleration in the dollar’s down trend we anticipate is also supportive of emerging markets and commodity prices.

Pay for the Privilege

Interest rates are the price of money. Foreign exchange is also the price of money. To be sure the relationship is not linear. We often present the relationship as cyclical. The dollar is in the part of the cycle when the reduced interest rate premium offered by the US undermines the greenback.

Traditionally, we place an emphasis on short-term interest rate differentials. However, because of the capital market disruption the term structure remains skewed. Libor term rates are still at an unusually high premium to sovereign rates. This has forced us to look further out the curve.

As a proxy for the euro-zone, it is common to use German interest rates. Germany now offers a small but growing premium over US interest rates for the two-year and five-year notes. Over the past five days, alone, the US 2-year note yield has fallen 20 bp to 3.91%, while the Germany 2-year note yield has fallen 5 bp to 4.07%. Over the coming weeks that spread should continue to widen in Germany’s (euro-zone’s) favor.

In recent days, the US 5-year yield has fallen below similar German yields. Over the past five days, the US 5-year note yield has fallen 18 bp to 4.15%. In the same time, the German 5-year note yield has fallen 7 bp to 4.19%. This premium that Germany (euro-zone) offers should continue to increase in the period ahead.

The US continues to offer a premium over Germany (euro-zone) on 10-year rates, but it is diminishing and will likely completely disappear later this year. At the start of the year, the US offered about 75 bp more than Germany. Now the premium stands below 20 bp, falling about 5 bp over the past week.

Forward currency rates are simply a function of spot or cash rates and the interest rate differential. As German rates rise above US rates, long-term investors have to pay for the privilege of holding dollars. And frankly they seem to be reluctant to do so. While it is generally acknowledged that the August TIC data was skewed by the market turmoil, it did represent the second consecutive month that private foreign investors seemed to pull back from long-term investments in the US.

Trajectory of Policy

Currently the Fed funds target is 4.75%, while the target rate in the euro-zone is 4.0%. This spread is also likely to narrow considerably in the coming months. Indeed, it is possible, especially if the IMF’s pessimistic forecast of the US economy is accurate (1.9% GDP in 2008 down from the 2.8% estimate made this past July), that the US policy rate moves below the ECB target rate.

The US economy appears to have expanded by around 3% in Q3 which, as was the case in Q2, put it at the top of the G7. However, Q3 is passé. Federal Reserve Chairman Bernanke called Q3 growth firm. The risks appear in Q4 and Q1 08. The housing market still poses the greatest risks to the economy. Data in recent days included a plummet in housing starts to 14-year lows. They are now almost 50% off their peak and the bottom is still not in sight, according to industry experts. Moreover, confidence at the National Association of Home Builders is at record lows—below the low set during the 1990-91 recession.

While the paralysis that struck the capital markets in August seems to be easing, conditions have not returned to normal and in any event, still seem fragile and disruptions can still occur. As Bernanke noted in his recent speech, there is an “unusually high level of uncertainty”, but both officials and investors see the uncertainty skewed to the downside.

With some measures of US inflation easing and some easing of labor market conditions becoming evident, an argument can be made that the setting of monetary policy is still tight, judging by metrics like the Taylor-rule, giving the Fed more room to maneuver. The dramatic steepening of the yield curve seen in recent weeks (2-10 curve has gone from inverted to more than 50 bp positively sloped) should not be seen as much as a deterrent to the Fed as an aid to financial institutions for whom a flat (or inverted curve) is often troublesome.

Conclusion

We have warned previously of the downside risks to the US dollar in the fourth quarter. We are now seeing scope for even more dollar losses than we previously envisaged. Investors should be prepared for an acceleration of the dollar’s decline, which will overshadow other developments. A falling dollar is also likely to be supportive for emerging markets and commodities.