The dollar discounts a better future
The weak U.S. dollar and oil speculators took centre stage as Group of Eight finance ministers gathered in Japan on Friday to grapple with surging inflation and a slowing global economy. The second paragraph summarized the main challenges as follows:
"We remain positive about the long-term resilience of our economies and emerging market economies are still growing strongly. However, the world economy continues to face uncertainty and downside risks persist. Further declines in housing prices in the United States and greater strains in the financial markets may adversely affect the global outlook. Elevated commodity prices, especially of oil and food, pose a serious challenge to stable growth worldwide, have serious implications for the most vulnerable, and may increase global inflationary pressure. These conditions make our policy choices more complicated. ..."
The communique lauded certain central banks for their bold action in response to the sub-prime crisis, noting that financial conditions had improved somewhat. Inflationary pressures, however, were the central theme in the U.S. markets. The first week of June saw an enormous rise in volatility as currency markets reacted to central bank statements on both sides of the Atlantic. First the dollar made the biggest jump against the euro since 2005 as Federal Reserve Chairman Bernanke said that economic risks have faded, raising speculation policy makers will increase borrowing costs this year to contain inflation. Then, European Central Bank President Jean-Claude Trichet said that the bank might raise rather than lower rates "a small amount" at its next meeting. The reaction that followed in the currency markets was dramatic. The "Bernanke rally" was completely reversed by the "Trichet ambush", leaving dollar bulls and dollar bears equally confused by Friday afternoon. The dollar managed to recover last week, after Spanish and Portuguese finance ministers both publicly expressed concern regarding Trichet's remarks, and the Italian government urged Europe to consider other methods. The fact that Irish voters rejected the Lisbon Treaty in a referendum did not help the Euro either. Take a look.
The combination of signals by the Federal Reserve and hard data pointing to an "unexpected" resiliency of the US economy is the main force behind the dollar's best weekly showing against the yen in nearly four years and against the euro in about two years. The first chart shows the Euro-Rally that culminated in April, when we wrote about it, in a sort of Euro-Mania. As is often the case, as soon as a near consensus develops in the markets, it is time to take the other side. The second chart shows the Euro/Dollar relationship since the beginning of this year. A breakdown from the $1.54 area would put $1.48 as the next target in play. This would constitute a positive development because a rally in the dollar could be constructive for the global inflation story. Nevertheless, the ECB's tough stance is good news for inflation hawks on both sides of the Atlantic, particularly when the stance is joined with the Fed's renewed focus on inflation because the combination puts pressure on commodities markets. This was also expressed in this weekends G-8 statement, where energy and food prices were singled out as the most prominent threats to stable growth worldwide. Although an early rise in European short term rates might at first blush appear to be a prescription for a stronger euro, this must not necessarily be the case, for it presumes that interest-rate parity (i.e., widening yield spreads will result in increased capital flows into the euro relative to dollar assets) is the only consideration for international money flows. This, however, must not automatically be the case. By raising interest rates, the ECB would accelerate recent signs of slowing economic growth in Southern Europe, hence altering the relative growth story in ways that could benefit the dollar. Moreover, if U.S. credit market problems stay in the background, a top reason for selling dollar assets will be removed. Other factors likely to support the dollar include reduced growth rates in Asia (because of inflation and attempts to control pollution in China), the prospect for housing legislation in the U.S., signs of a shallow U.S. recession, and a change in U.S. leadership. Especially the likelihood of a shallow recession increased just this past week. Retail sales increased 1% in May overall and 1.2%, excluding automobile sales from April. There were also sharp revisions upward to previous months, totaling nine-tenths of a percentage point both overall and excluding automobiles. The increases had nothing to do with rising gasoline prices, however. Excluding sales of automobiles and gasoline, retail sales increased 1% in May following gains of 1.1% in April and 0.5% in March. The April and March figures were upwardly revised by 1.3 percentage points compared to what was previously reported, which means that the revisions to the headline figures were rooted in categories unrelated to gasoline. These figures will force estimates upward for the current quarter's gross domestic product.
The first chart above shows total retail sales excluding food services, but including car and gasoline sales. Retail sales are weak, to be sure, but they are not falling off a cliff, as one would suspect in the current doom and gloom environment. A 2 percent annual rate of change is weaker than we have seen in a long time, but growth is at least positive. Strength in retail sales in the context of lean business inventories will likely boost manufacturing output, which could mean that the ISM manufacturing index, which currently stands at 49.6 moves above 50.0 by the end of the summer, giving a boost to investor sentiment and likely lift the value of risk assets, including share prices. Sustainability will be a key question, of course. Nevertheless, there is a chance that the increase in sales will ignite the production cycle and produce a self-reinforcing virtuous cycle of increases in production, income and spending. The second chart above shows the ISM non-manufacturing index, which reflects the service sector of this economy. This index already bounced back into positive territory and continued to climb in May. You can see that the index spiked down during the 2001 recession and bounced back in similar fashion. This strength and the pattern-similarity give me hope that the recession may turn out to be shallow or may be avoided altogether. The dollar strength in any case is arguing for the latter. Let us hope that we can get off that easy.