What it Takes for the Dollar to Recover

Clearly any recovery in the dollar requires someone to buy it. It may be a worthwhile exercise to consider who would buy the dollar. Among short-term players, using the IMM Commitment of Traders, anecdotal and proprietary data, speculators have amassed a large short dollar position. The net short US dollar positions in the futures market stand near record highs. The trade is crowded and in such market conditions, it does not take much to spark a short-squeeze.

Central banks continue to buy US dollars and this has largely been lost in all the talk of reserve diversification and the establishment of sovereign wealth funds. The Federal Reserve’s custody holdings data, which offers information that is not necessarily contained in the TIC data (which picks up activity only through the US banking system) showed a $6.5 bln increase in the latest week of Treasury and Agencies for foreign official accounts). Since the fourth week in June, the Fed’s custody holdings have risen by about $40 bln and year-to-date almost $250 bln (which is well more than the US budget deficit this year, for example).

Americans themselves have been selling dollars to invest in foreign equity markets. If they stopped chasing yesterdays’ returns and began buying US shares then that might also reduce pressure on the greenback. One week does not make a trend for sure, but weekly US equity flows may be worth monitoring a bit closer. TrimTabs reports in the latest week, mutual funds and ETFs that invest in the US took in $5.3 bln after a combined inflow of less than $800 mln in the previous two weeks. Mutual funds and ETFS that invest outside of the US, however, took in $7.4 bln compared with about $7.5 bln in the previous two weeks.

In some ways, the focus on who could be dollar buyers begs the question of why. Leaving aside the central banks, whose reserve accumulation this year already surpasses the net new sovereign issuance from the US and Europe for the entire year, what will prompt investors to buy dollars?

Even though, as they say, past performance is no indication of future returns, it may be helpful to review the recent price action. Like a cascading effect, the Australian dollar, sterling and the euro put in their spring peaks against the dollar between mid- and late-April. The dollar recovered for several weeks. The Australian dollar bottomed in late-May. Sterling in early June and the euro is the middle of June.

The macro-economic context for the price action was first the weak economic performance in Q1 that prompted the market to price in not one but several interest rate cuts by the Federal Reserve. Recession talk seemed to reach frenzy levels. Then as early Q2 data began coming in, it became clear that rather than continue to slump, the US economy was rebounding smartly. That appreciation, coupled with the Fed’s insistence that the upside risks to inflation were greater than the downside risks to growth, underpinned what could have been a simply technical correction.

For a few days in mid-June the market had actually priced in a small chance that the Federal Reserve would hike rates before the end of the year. However, that view was quickly reversed as was the dollar as Bear Stearns hedge fund problems came to light. And that was that. As further news of continued contraction in housing, the rising delinquency rates and falling prices new anxiety was sparked over the general credit conditions.

Although comments from Fed officials, including Chairman Bernanke’s testimony this week and the FOMC minutes from last month’s meeting seems to point to Fed policy decisively on hold, the market continues to discount a chance of a cut. That chance was as small as about 1 in 10 after the stronger than expected US June jobs report, but has since risen to almost a 30% chance (using the Dec Fed funds futures contract).

If the US dollar is going to recover, it seems that the market needs to abandon its predilection that the Fed wants to cut interest rates. Since the Fed stopped hiking rates in June 2006, the market has consistently, with the noted exception above, assumed that the next move is a cut.

Interestingly in the middle of the second quarter several large investment banks did in fact revise their Fed forecast and no longer looked for multiple cuts. Some gave up on a cut entirely this year, others reduced it to a single cut late in the year. It is telling that core measures of inflation had begun slipping as the Fed view shifted.

This is important because it suggests that it is growth not inflation that is the key to Fed expectations. In terms of the budget deficit, US President Reagan, Clinton and now Bush have demonstrated the ability to grow out of the fiscal straits. Economic growth may provide a panacea or at lease make it easier to absorb the dislocation caused by the sub-prime/housing market problems.

Next week, on July 27th the US will report its first estimate of Q2 GDP. The Bloomberg consensus calls for a 3.2% annual growth pace. Even though this is consistent with a stark improvement from the 0.7% pace of Q1, the risk is on the upside. Inventories and trade likely swung from around 1 percentage point of drag on growth to a net positive contribution. Residential construction remains a drag, but it looks to have been reduced. The consumer pulled back after a shopping spree in recent quarters, but foreign demand, non-residential construction, and business investment picked up the slack.

However, the dollar likely needs evidence that the pick up activity in Q2 was not just pay back for the soft Q1 and that the economy enjoys good momentum in Q3. This is consistent with the Federal Reserve’s central tendency forecast.

Of course, the general credit conditions do matter. There has been some re-pricing of risk and widening of some credit spreads, but by all comparisons but the most recent period, spreads are still relatively tight. If growth and the evolution of expectations of the trajectory of Fed policy are key to the dollar, the equity performance of the financial sector may offer a short-hand to wading through the morass and alphabet soup of the mortgage backed securities and derivatives markets. The health of the financial system may be the key to weathering the potential storm.