Rudi's View | Nov 27 2006
By Rudi Filapek-Vandyck
Come December, come US dollar weakness. The two events have gone hand in hand over the past few years. Again the odds seem in favour of a repeating exercise over the next few weeks.
Various explanations have been given by currency experts over the past few years. All seem logical, though equally unconvincing. Fact remains, as again highlighted in a study by Credit Suisse this week, the US currency tends to book its biggest falls in the closing weeks of the calendar year. The study found the USD has lost terrain against the euro in each December since the year 2000.
On average, the study concludes, the US dollar declines by 2.6% more than normal in December. The flipside is that these losses are more often than not reversed in Q1 of the following year.
This now leaves investors with two major questions: will the pattern repeat itself this year and will the currency swiftly bounce back in the first quarter of 2007?
The answer to the first question appears to be “yes”. As pointed out repeatedly by US based trading guru Dennis Gartman, the US dollar and the euro have been locked into a narrow trading range since May this year, on balance moving sideways via small deviations on “either side of 1.2700”. The “new equilibrium”, as Gartman calls it, was broken on Thanksgiving Day, with the euro breaking higher and the US dollar lower. So convinced is Gartman that the event heralds a new trend for both currencies, he has advised his clientele to immediately adjust portfolios and market positions accordingly.
Says Gartman: “It is not the news of the trade deficit that is pushing the US dollar lower and/or the EUR higher; nor is it the suggestion that the Fed shall remain “on hold” for some while into the future while the ECB appears ready to move to higher rates at the short end sooner rather than later; nor is it the recent election of the Democrats to the status of the majority party in both the House and the Senate; nor is it the recent comments by several of the central banking heads from the Persian Gulf suggesting that they are quietly moving away from the US dollar as the very nearly sole reserve asset, and are instead moving into EUR denominated assets, and into assets denominated in other currencies with whom they do material amounts of international trade… and we could go on.
“Any single one of these “news” items is not sufficient to push the dollar materially lower; however, in aggregate, they are. That, we think, is what is happening: it is the aggregate accumulation of these bearish bits and pieces that has the dollar on the defensive.” Parallel to the bearish US dollar event last week, gold charts generated a bullish signal for the precious metal.
Maybe Gartman, like so many other market participant, is too much focused on the US dollar and the US economy. Maybe this year the mounting pressure on the greenback may not have so much to do with the US, but more so with Europe. Morgan Stanley’s currency team, a long standing supporter of the US dollar, recently revised its currency forecasts expecting the USD/EUR to rise to $1.31 by year end. This is up from 1.24 previously.
The reason for this dramatic change in view, explains Morgan Stanley, is the expectation the European economy is about to be positively re-rated for 2007. Currency expert Stephen Jen and his team believe this is likely to cause “an overshoot in EUR/USD” as well as “a more symmetric cyclical dollar correction than we had envisaged before”.
Over at Credit Suisse a similar view rules: “The majority of clients we speak to have not believed that the relative resilience of European growth can last (this is reflected in a consensus economic forecasts of just 1.9% GDP growth in 2007). Last Thursday’s IFO survey shows that European growth has decoupled from US growth and thus clients need to re-appraise their European GDP outlook.”
It is this change in market view about Europe’s economic prospects that will fuel the next wave of US dollar selling, Morgan Stanley and Credit Suisse suggest. Weak economic data over the next few weeks are expected to further contribute to expectations US interest rates will soon be on their way down, while central bankers in Europe and Japan are likely to remain a tightening bias.
Forget about large current account deficits, or central bankers moving to diversify into yen and gold and out of US dollars: the market is about to zoom in on the shortening interest rate differential between the US and the rest of the world. The result of this will be a weakening USD.
In the view of US dollar bulls like Credit Suisse and Morgan Stanley this process won’t last very long though. Neither believes a repeat of the previous USD correction from 2002 until 2005 lies ahead. The difference between now and then, Credit Suisse argues, is that the interest rate differentials still favour the US dollar in both nominal and real terms. Even if interest rates in the US and most other major economies will move closer throughout the year, Credit Suisse sees European rates still at 1.25% below US rates (from 2% now) by the end of 2007.
But what applies to the euro and the yen does not apply to the Australian dollar. Even if the Reserve Bank of Australia does not raise interest rates at its next meeting in early February, chances are high the RBA will nevertheless continue its tightening bias. Australian official interest rates are already significantly higher than the Fed Funds rate (6.25% versus 5.25%), the overall perception that US interest rates are on their way down leading to a likely larger interest rate gap between both countries is thus bound to support the Australian dollar in the months ahead.
This is the view of Craig Ferguson, ex-currency expert at JP Morgan and later ANZ who nowadays co-manages hedge fund Antipodean Capital. While not necessarily agreeing with all of the above, Ferguson has been bullish on the Australian currency for a while now. If anything his view has further strengthened over the past few weeks.
Ferguson sees four major factors supporting his view that the Australian dollar could well trade as high as 0.90 against the greenback next year. Apart from the widening interest rate differential (Ferguson has a different time schedule though), he sees AUD support coming from relatively strong commodity prices, a gradual reduction in Australia’s traditionally high current account deficit and the fact that most super funds in Australia don’t have a currency hedge in place.
If the Australian dollar breaks through 0.80 next year these funds are likely to decide they need currency protection against their offshore exposure. If Ferguson’s vision proves correct, this will provide the AUD with an extra boost next year.
Investors better take note.