Dollar: Currency Hurting From Weak Growth And High Inflation

John Lewis - Thu 24 May, 2007

After a recent attempt to break through the previous all-time high against the euro at 1.3668, the dollar has yet again staged something of a recovery. However, this is likely to be a brief event. The main casualty is the current combination of weak growth and higher than desired inflation, hurts the currency because of the policy inertia which increasingly raises the spectre of stagflation a phenomenon of zero growth with high or relatively high inflation. Contrast the US economy to either the UK or Eurozone economies and the picture is quite different.

The US dollar has been weakening against the euro and
sterling since the highs made in November 2005. But let’s
take a look at what has driven the change in the US
currency’s fortunes.

First, the worsening US trade deficit held the attention
of traders and analysts alike as they debated its
sustainability. After a brief period of improvement, this
deficit has again begun to deteriorate. That’s dollar
negative.

At the same time, the anti-dollar trend was fuelled by
the burgeoning slowdown in the US housing market in late
2005, which we now know led to a general economic
slowdown. The effects of this are still in play and
resolution remains uncertain.

But although the dollar’s decline has a clear trend, it
has been frequently interrupted by periods of sideways
trading and sometimes quite sharp corrections. After a
recent attempt to break through the previous all-time
high against the euro at 1.3668, the dollar has yet again
staged something of a recovery.

However, this is likely to be a brief event. The US
economic fundamentals continue to be very mixed. On the
one hand, growth is now very weak as evidenced by the
recent release of US first quarter GDP, which at only
1.3% annualised is very anaemic.

On the other hand, inflation remains a problem for the
Fed; released at the same time as the Q1 GDP report was
the Q1 core personal consumption expenditure index or PCE
for short. This increased by 2.2% on the quarter, and as
the Feds preferred inflation measure, it played to their
current concerns.

This is making life awkward for the Fed, as they rate the
risk of inflation failing to moderate greater than the
risk of the economy falling towards recession.

But if they act now and tighten policy further to ensure
inflation does indeed correct lower, the risk of the
economy drifting closer towards recession will increase.
Although the US interest rate and Government Bond markets
periodically flirt with the idea that the Fed will soon
ease policy to help growth, that is clearly an irrational
expectation. To ease now or any time soon would
simultaneously achieve two undesirable results:

* inflation would likely move higher as faster growth
driven by cheaper money would encourage businesses
to raise prices; but more importantly,

* the Fed would lose its hard won reputation for
being a tough inflation fighter, which would make
it much harder for them to ultimately tame the
higher inflation that would result.

This leaves them where they have been since August 2006 –
on hold – and that situation is likely to endure for
several more months yet.

The Fed is “gambling” that the current weak level of
growth, combined with their past policy actions will
produce the result they desire. When Central Banks change
official interest rates it can take anything from 12 – 18
months before their impact is fully felt on the economy.
On that basis the Fed has a couple of months to go before
all of its past actions are exerting maximum impact on
inflation, as their last rate hike was June 2006.

However, at some point they will have to come off the
fence and if the present scenario is still in play, my
view is they will hike rates. I do not see the Fed
risking its hard won anti-inflation credibility or the
hard won gains made against inflation in the last
10 – 15 years.

But until that point is reached the main casualty is and
will continue to be, the dollar. The current combination
of weak growth and higher than desired inflation, hurts
the currency because of the policy inertia which
increasingly raises the spectre of stagflation – a
phenomenon of zero growth with high or relatively high
inflation. In all probability it won’t occur, but
currency traders are not used to an impotent Fed and
right now that is what we have.

Contrast the US economy to either the UK or Eurozone
economies and the picture is quite different.

In the UK growth remains strong, driven by double-digit
house price increases and solid domestic demand. This is
despite several recent interest rate hikes. With
inflation uncomfortably above the Bank of England’s
target of 2.0%, further rate hike(s) are expected, even
after the most recent move that took interest rates
to 5.5%.

Similarly in the Eurozone growth is strong and the most
reliable indicator of future economic activity – the
German IFO survey – currently flags a further period of
very strong growth. Although Eurozone inflation is
currently below the European Central Bank’s (ECB) 2.0%
target at 1.9%, the ECB has forecast inflation to pick up
later this year, driven by the strength of economic
growth and the rapidly expanding money supply, which they
closely monitor.

So unlike the Fed, the Bank of England and the ECB have
the freedom they need to raise interest rates as and when
they judge necessary.

So how will this impact the dollar in the coming weeks
and months and indeed over the rest of this year?

Although the dollar’s decline has, as already stated,
paused, this is likely caused by the lack of technicals
available for traders to trade off.

Above Dollar/Euro 1.3668 traders are entering the
unknown, and even for sterling/dollar which has a well
charted history above the 2.0000 dollar level, it last
traded convincingly above it as far back as 1992. And in
any case, time spent around those levels is usually
relatively brief.

However, these levels, especially in Dollar/Euro, are
psychological, rather than actual barriers and the body
of fundamental/macro evidence will eventually drive the
dollar through.

And although the euro is still young, the dollar has been
weaker than this against the former German Mark, which
can still be charted, or by using a historical synthetic
chart of the Euro below.

Click on this link for a Synthetic Dollar/Euro Chart: 

http://www.fleetstreetpublications.co.uk/chartdisplay/#graphic5

It’s difficult to choose specific entry levels and stop
losses – there is bound to be some volatility around such
key dollar levels. Let’s just say that my target for
cable (sterling versus the dollar) by year end is 2.2000,
and for Dollar/Euro 1.4550.

Regards

John Lewis
For The Daily Reckoning

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