New Dollar Update

The bullish dollar case I argued remains intact as February draws to a close. The bull case was based on a conviction of the underlying resilience of the US economy, which in turn would prompt more Fed tightening that the market appreciated. Widening interest rate differentials would lend support to the greenback.

At the end of last year, the market has discounted a 4.75% peak in the Fed funds rate. Second thoughts were seen in January. The July Fed funds futures contract is finishing Feb about 30 bp below when it finished last year as the market anticipates a 5.00% Fed funds at mid-year.

While this still seems to be the most likely scenario, what seems less reasonable to me is the belief that Fed funds peak there. The market has yet to fully appreciate the magnitude and duration of the current tightening cycle.

There are several reasons why more Fed tightening is likely. First look at the macro-economic performance. To use the vernacular, the US economy is kicking butt here in Q1. GDP looks to be growing a heady pace that might even sport a 5-handle. The unemployment rate stands a 4.7%.

Capacity utilization rate eased in January below 81%, but this reflected a sharp drop in utility output due to the unseasonable warm weather through much of the country. Manufacturing capacity utilization rose to 80.5% from 80.1% in December to stand at its highest level since July 2000. I would not necessarily draw much significance from these two factoids, but for the fact that the Federal Reserve has suggested that “resource utilization” is a concern. Moreover, to the extent, the course of Fed policy is data dependent; the Federal Reserve has not ended a tightening cycle with such a macro-performance.

Second, the fact that the long-term interest rates have not risen much over the past 18 months that short-end rates have been hiked, suggests that the Fed will have to do more of the heavy lifting, if it is going to achieve the desired degree of tightening.

But it is not just the price of money (interest rates) that are implying less restrictive monetary conditions, but the quantity of money continues to grow at a robust pace. For example, the year-over-year growth rate of M3 rose at an 8.1% pace in January, accelerating from the 4.9% pace seen in June 05 a 5.7% pace in June 04, when the Fed began its tightening cycle. Money supply measured by M3 is rising at its fastest rate since early 2002.

Whenever I have painted this picture, the doom and gloomers say what about the inverted curve, which portends a recession. It is true that the yield curve has an excellent track record of preceding recessions. It is also true that during periods in which the US curve is inverted, the dollar tends to appreciate.

In addition, another useful rule of thumb is that the stock market tends to peak 6-8 months before the economy. As you know, the Dow Jones Industrial Average is at it highest level since 2001 and has held above the 11,000 threshold since Feb 15. The S&P 500 index is also at its highest level since 2001. It is true for even for a broader index like the Wilshire 5000, which made new multi-year highs yesterday.

What these observations have in common is liquidity. This contrasts with fair valuation models, formal or informal that market participants often use. Ideas that certain prices, like for gold or money are telling us something about the economy or larger market assumes a fair value model. However, if it is a question of liquidity, what may be generated is not a signal but noise.

The liquidity hypothesis can explain a lot of the seemingly anomalous price action, like the collapse of quality spreads, like corporates and US Treasuries or emerging markets and US Treasuries, in the fixed income space. It is true that corporate America’s balance sheets are vastly improved, with a significant minority of US companies having more cash than debt. It is also true that economic conditions for a number of emerging market countries have improved in recent years. Many East Asian countries enjoy current account surpluses. Russia and a number of Latin American countries have paid down debt. While there has been some fundamental improvement, but the abundance of liquidity seems to be a key critical force.

In the near-term the US dollar appears vulnerable to a setback. This setback will coincide with a slight narrowing of short-term interest rate differentials and as the market awaits fresh trading incentives. In this phase, the risk is that the euro firms to test $1.1970-$1.2000 before a fresh low risk sale opportunity may present itself. Sterling can head back toward $1.7600. The dollar made a new high for the year earlier today and now is reversing today (posting what is technically a key reversal). Potential for the greenback, which is currently quoted around CHF1.3145, extends toward CHF1.2900-50. The dollar may not suffer as much against the yen as cross positions are adjusted. A break of the JPY115.70 would be significant and would warn of a potential move toward JPY114.00.