Poor Conjugation: US Economy and the Dollar

The U.S. jobs data caps a string of impressive data that should but probably won’t silence the pessimists. Already the unseasonably warm weather is being cited by some to dismiss the recent stability of new and existing home sales and the stronger than expected employment data. It is unlikely that one of the biggest bond fund managers will change his call for 100 bp cuts in the Fed funds rates this year. Nor will many of the more aggressive economists at some of the investment houses who make their mark by their unceasing ability to find a cloud in every silver lining change their tune.

Nevertheless, the recent economic data reinforces our more optimistic outlook. We suspect the consensus is mis-conjugating the verbs. The U.S. economy is not slowing down. Rather, it slowed down and now appears to be poised to reaccelerate. The mis-conjugation of the verb also applies to the euro-zone and Japan. Those economies are not accelerating, but rather accelerated previously and now are moderating.

There were two widely recognized and well documented head winds to the U.S. economy—housing and autos and their related sectors. Those headwinds may not have disappeared, but their drag has lessened. New home sales rose 3.4% in November, more than twice what the consensus expected and stand almost 7% above the trough set in July. Existing home sales were expected to have declined in November and instead rose 0.6%, the second consecutive monthly rise after a run of consistent declines since April. The most recent mortgage application data, while especially volatile at the end of last year, is more than 10% above its trough set in October. Our argument is not that the housing market has definitely bottomed. Rather we make a more modest claim: that the housing market will not subtract as much from growth or sentiment as it has done.

In any event, we have consistently downplayed the link between the housing market and consumption. The key to consumption in the U.S., we argue, is not housing, but income and credit conditions. Personal income in November stood nearly 6% above year ago levels. To the extent that wages are a critical form of income, the December jobs data points to continued gains. Average hourly earnings rose 0.5%, the most since April. On a year-over-year basis, average hourly earnings rose 4.2% in December, the highest since late 2000.

The one bet that has proven wrong time and time again has been a bet against the U.S. consumer. Personal consumption expenditures, which drives roughly 70% of the economy has reaccelerated since the summer. Specifically, in July personal consumption had slowed to a 2.3% year-over-year rate. It has risen steadily since and as of November was up 3.8% above year ago levels. Personal consumption in Oct and Nov has already matched the Q3 rise and based on some preliminary data, it appears that personal consumption rose in December.

That brings us to the second headwind to the U.S. economy: autos. The cuts in production have helped address the inventory overhang problem. December vehicle sales were at a 16.8 million unit pace, the best since the July outlier of 17.2 million. This is the third best performance of the year. Admittedly, auto sales tend to be strong in December and it may be premature to conclude that the head wind has diminished substantially, but that looks to be the case. Moreover, some foreign-based producers are expanding or plan to expand capacity in the US. The point though is that the auto sales figures suggest favorable PCE and retail sales figures for December.

Business investment also appears to be making a positive contribution to growth. In Q2 2006, non-residential investment slowed to a 4.4% increase, the lowest since Q1 2004. It recovered to a 10% pace in Q3. Proxies that some economists will use to help forecast investment, like the shipment of durable goods, appear to stabilizing.

It is not simply domestic demand that is healthy, but foreign demand is strong as well. The most recent trade data covers the month of October, exports were up 13.8% year-over-year. The U.S. trade deficit has improved more than expected during the first ten months of 2006 and the improvement since the summer has been especially pronounced. After peaking in August near $68.5 billion, the deficit has fallen by $10 billion to stand at $58.8 in October. We think there are real and conceptual problems of comparing the trade deficit with the Treasury’s International Capital report (TIC data), though we recognize that it is a metric that the media and some analysts like to cite. By this measure, the U.S. trade deficit is being overly financed by net foreign purchases of U.S. assets.

The U.S. dollar itself has been hobbled especially against the European currencies, by three main considerations: interest rate differentials, the US current account deficit and the diversification by public and private investors away from the greenback. We have argued that the diversification story has been exaggerated by some observers and the media. The latest reserve figures released by the IMF at the end of last year lend support to our view. In Q3, the dollar’s share of global reserves, where the composition has been declared, increased marginally. In fact, collectively, central banks hold more dollars in reserves than they did a year ago. Specifically, the IMF data suggests that dollar-denominated reserves in Q3 were $252 billion more than they were in Q3 2005.

The value of euro reserves in the same period rose by $125 billion. Reports that several central banks, including the Swiss National Bank and the Russian central bank had bought yen for reserve purposes captured the market’s imagination. But the IMF data indicates that the value of yen holdings rose an inconsequential $200 million in Q3 and was actually down almost $5 billion since Q3 2005. The value of sterling holdings rose $5.7 billion in Q3 and were up $36.3 billion from Q3 2005.

Even this might overstate the actual amount of non-dollar currencies bought. An important consideration in the valuation of reserves in dollar-terms is the movement of the exchange rate. For example, the dollar’s decline against the euro in the January-September 2006 period accounts for almost half the rise in the dollar value of the euro-reserve holdings.

The IMF data is a useful reminder that reserve diversification is not a zero-sum undertaking during periods in which reserve assets are being accumulated, as is the case now. And whatever diversification is taking place it is quite gradual. Lastly shifting currency prices may be contributing to the diversification more than is generally appreciated or acknowledged.

The current account deficit remains large, but the empirical record suggests that there is a big difference between being able to forecast it and forecasting the dollar’s movement. And, as we pointed out above, the U.S. trade deficit, the driving force behind the current account deficit, has improved and by more than expected in recent months.

This leaves the interest rate differential argument as the most potent dollar bear argument in our view. In our informal model of the euro-dollar rate, we place greater emphasis on the short-term interest rate differentials. With the recent string of constructive U.S. data, which contrasts with the weaker than expected euro-zone data, there is a reasonable chance that the short-term interest rate differentials stabilize and perhaps even widen back out in the U.S. favor.

This analysis and summary of our views warns of additional near-term U.S. dollar gains, especially against the European currencies. We are also reminded of the recent seasonal pattern for the dollar to recover at the start of the year from the frequent sell-off at the end of the proceeding year. In the near-term, we see the downside risk on the euro extended toward $1.2825-$1.2925. As a guide, note that the 100-day moving average comes in near $1.2870, and the 200-day moving average, which the euro has not traded below since March 2006, comes in near $1.2750. On the upside, we expect the euro to be capped in the $1.3100-40 area.

The downside risk for sterling extends toward the $1.90 area. The 100-day moving average comes in near $1.91, while the 200-day moving average is at the more distant $1.8760 area. Sterling has also not traded below its 200-day moving average since last spring. On the upside, the $1.9450-$1.9500 area will likely cap bounces.

The sharp drop in the euro and sterling in recent days has left short-term technical indicators terribly over-sold and a bounce in the coming days would likely provide a new opportunity to short. Many speculators have probably been trapped with stale long currency positions and will likely see a bounce as an opportunity to pare losses, while real investors are likely raise hedge ratios on European investments or reduce their exposures outright.