The View From 10,000 Feet

The New Year has begun with a bang. Global equities have rallied. Bond markets have generally firmed. The dollar has slipped against most of the major currencies and regional Asian currencies. Emerging market currencies in general are off to a good start, led by the South African rand (+~5%) and the Brazilian real (+~3%).

There are two main imbalances in the US economy that are points of contention among market participants. The first is the large trade deficit and the second is concern about the slowing of the housing market. Ironically, insight about the first helps shed light on the latter. Specifically, strengthening exports and the implications this has for US industrial output. This points to a potential offset to the headwind that is being generated by the gradually slowing of the US housing markets. Although the November trade balance was the third largest on record, the fact that it was reported well below expectations and the October deficit was revised to reflect a smaller deficit warns that economists will likely be revising upward preliminary Q4 GDP forecasts. On balance, the recent data should raise investor confidence that the US economy most likely recorded its 11th consecutive quarter with growth in excess of 3% of GDP.

Although the weaker than expected headline gain in the December non-farm payroll report prompted hand wringing by the doom and gloom camp, the market has managed to focus on the economic signal of the report and not the noise. The two important take-away points were the large upward revision to the November series and the unusually large number of people who could not find work due to weather considerations. A rate hike at the January FOMC meeting, the last to be chaired by Alan Greenspan, is as done of a deal as these things get. The real controversy has been over the outlook for the March meeting, Bernanke’s first. The market attributes a slightly greater chance that the FOMC hikes rates in March than it did prior to the recent batch of data.

Comments from the Chicago Fed President and a voting member of the FOMC are very revealing. Many pundits try to pigeon-hole central bankers into “hawk” and “dove” camps. This can be misleading as central banker views change with economic circumstances and most of the time under Greenspan, Fed decisions were reached unanimously. With that caveat in mind, Moskow clearly put himself in the more hawkish camp in late November warning the market that the Fed may not stop raising rates at neutrality (when the US Fed funds rate neither stimulates nor restrains economic activity). Moskow’s comments on January 12th reiterated that message and more.

Moskow made two points which together would seem to be more hawkish than his November comments, especially given the data that has been released since his Nov 21 speech. First, without specifying the range, he indicated that the current 4.25% Fed funds target is the lower end of neutrality. Second he reiterated that there is nothing sacrosanct about neutrality. Higher rates may be needed.

Moskow also expressed concern about what may turn out to be the key policy focus going forward, namely “resource utilization”. Essentially if the series of rate hikes since June 2004 has been about the normalization of US monetary policy after the 2001 recession and deflation scare, then the next rate hikes may be directed to preempting the inflationary potential inherent in an economy without much slack. Clearly the US economy is continuing to expand at a pace that is absorbing what spare capacity exists. Moreover, his economic forecast was consistent with trend growth of the US economy for the foreseeable future. He called the Blue Chip survey consensus forecast for the US growth to average 3.25% for the next two years “reasonable”.

Although he has only one vote, Moskow likely speaks for others on the FOMC. In contrast, the President of the European Central Bank was not as hawkish as the market had expected following the decision to keep the key rate steady at 2.25%. In fact, some attribute the euro’s slide following the meeting to Trichet’s acknowledgement of the downside risks to the euro-zone growth prospects. Similarly, the Bank of Japan Governor Fukui seemed to sound content to let the extraordinarily accommodative policy continue for a while longer. Previously, the market was under the impression that he felt a greater urgency to reduce the amount of liquidity that the BOJ is pumping into the banking system.

The argument presented here does not exclude the possibility of additional near-term dollar losses. In fact, the risk is that the dollar’s downside correction from its run-up from the early Sept 05 through mid-Dec 05 has not completely run its course. Provided the euro continues to hold above the $1.20 level, where a central bank or two are thought to have an interest, the euro has near-term potential toward $1.2225. Against the yen, the dollar can retest the JPY113.50 level.

Many emerging market currencies also continue to look attractive. Asian currencies are in a win-win situation. Given the region’s integration with the US tech cycle, many investors view Asia as a leveraged way to play the US cycle. Alternatively, if investors seek to diversify away from the US, Asian currencies also stand to gain on ideas that they are moving increasingly into China’s economic orbit, or will do so over time.

The appreciation of the regional currencies has prompted expressions of concern by local officials and there is talk that one or more central banks might have intervened to slow their currency’s appreciation. Although such talk is unconfirmed, the $25 bln rise in the Federal Reserve’s custody holdings provides some circumstantial evidence for it. In this vein, the auction schedule of both the US Treasury and corporate America suggests plenty of “product” in which to place the official (and privately held) dollars. In the coming weeks, the US will sell about $100 bln of new paper including the re-introduction of the 30-year bonds. As a previous note indicated, Corporate America is likely to issue a record amount of bonds this year and they are being front loaded. Already this year, US corporates have sold about $40 bln worth of bonds.

In Latin America, the Brazil real and Mexican peso appear poised for additional near-term gains. The Brazilian central bank meets next week and, in the aftermath of soft inflation and real sector data, it is likely to accelerate its rate cuts from the 50 bp moves seen in Q4 05 with a 75 bp cut likely. Such a move would bring the overnight rate down to a still lofty 17.25%. The central bank has been buying dollars almost every day, but the high interest rates continue to underpin the currency through two channels. The first is through foreign investors buying Brazilian real bonds and equities. The second channel is from Brazilian companies issuing dollar-denominated bonds and swapping the proceeds into the real.

The Mexican peso has under-performed compared to the high flying real. Like Brazil, Mexico’s central bank is likely to continue to ease monetary policy when it meets again toward the end of the month (Jan 27). However, the near-term outlook for the currency remains favorable. The dollar recorded a double peak against the peso near MXN10.80 in December. The market convincingly took the dollar through the neckline that comes in near MXN10.60. The measuring objective is near MXN10.40, which corresponds to the dollar’s low from early December, but seems a bit aggressive. Later in the first quarter and for sure in the second quarter, the July elections in Mexico heighten the risk a weaker peso.