The dollar is down but not out. I am moderately bearish on the USD for the short and medium term, but I believe the recurrent talk of an imminent end to the dollar’s reign as the main reserve currency is way too premature to be taken seriously. The weakening of the USD over the last several weeks has been broad-based and driven by optimism about the global growth outlook and concern about the US public debt prospects. A trend reversal seems unlikely over the next six to nine months, and EUR-USD will likely rise towards a 1.50-1.55 range. A further moderate USD depreciation would be consistent with the needed rebalancing of global growth, but in no way signals a threat to the dollar’s dominant role in FX markets: There is currently no viable alternative to the USD as main reserve currency. In this context, the recent high-level policy discussions between the US and China are an encouraging sign that converging interests are beginning to foster closer cooperation to ensure a more balanced and sustainable global recovery. Fed Chairman Bernanke today called for the timely design of a US fiscal consolidation plan as a precondition for both financial stability and robust growth. His assessment of economic and financial conditions suggests to me that the Fed is unlikely to step up its UST purchases in the near future to push long term yields back down. I expect that tomorrow the ECB will confirm the prudent and sober stance outlined a month ago: it will keep rates on hold, provide details of the covered bonds purchase program, and leave the door open in principle for further monetary or credit easing, while confirming that the policy stance seems currently appropriate. The ECB will also reiterate its commitment to a timely unwinding of the policy stimulus when warranted. Overall, such an outcome would be consistent with further EUR strengthening, which the ECB might actually welcome now that oil prices are back on the rise. Mrs. Merkel’s surprise attack on the ECB and other major central banks is unhelpful but inconsequential, in my view: the ECB is already well aware of the importance of an exit strategy, as evidenced also by the lively debate within the Governing Council, which I see as healthy, and not a sign of potential paralysis. In the end, Mrs. Merkel’s pressure might paradoxically bolster the ECB’s credibility: having attracted sharp criticism from both France and Germany might well prove that the ECB is not only independent, but probably walking the right path…
Over the last five to six weeks, the dollar has been ambushed by two adverse factors: The most important has been the rapid spreading of signs of stabilization and recovery in the global economy, which unleashed an unexpectedly sharp recovery in risk appetite and triggered outflows from safe haven currencies, notably USD, JPY and CHF, and strong gains in equities and commodities. The second has been growing concern about the mounting level of US public debt, also reflected in rising long term bond yields and inflation expectations. This has been exacerbated by S&P’s decision to downgrade the UK’s outlook, seen by many as a reminder that no sovereign rating is safe. Caught in the crossfire, the USD has depreciated by about 9% against other major currencies (as measured by the Bloomberg USD index).
Fed Chairman Bernanke emphasized the need for fiscal consolidation in his Testimony to Congress today. As ADP employment and ISM non-manufacturing data confirmed previous signs of stabilization, Mr. Bernanke expressed moderate confidence that economic activity is about to bottom out and recover, thanks also to the powerful policy stimulus and the attendant improvement in short-term funding markets. He cautioned that the recovery would be slow, and would hinge on a continued stabilization of household consumption and a gradual normalization in the financial sector—but consumption data since January and the results of the stress test on banks are somewhat reassuring in this respect. Noting the large projected increase in the debt to GDP ratio, to 70% in 2011 from 40% before the crisis, he signaled the need to start devising a fiscal consolidation strategy as a key precondition for both financial stability and robust growth. He also pointed to the increase in public debt as one of the main reasons behind the rise on long term bond yields, together with renewed optimism on the growth outlook and declining risk aversion. Overall, his remarks do not seem to presage a stepping up of UST purchases in an effort to drive yields down.
In the short term, there is a significant risk of a temporary correction in both risk appetite and the USD: markets have gotten ahead of themselves in their enthusiasm for the recovery, and a setback in macroeconomic indicators could trigger a profit-taking pause on risky assets, benefiting the dollar. Over a six to nine months horizon, however, a trend reversal seems unlikely.
A further gradual weakening of the USD would be very beneficial to the sustainability of the global recovery. There has been much talk about the need to correct the infamous global macro imbalances, but the global recovery still relies on US consumption (now public rather than private). For a recovery to be sustainable this will need to change, and some further weakening of the USD would help reduce the US current account deficit and stimulate import demand in some of the surplus countries. To be beneficial, however, the move needs to be gradual and controlled—and the tone of the recent high-level policy discussions between US Treasury Secretary Geithner and key Chinese officials provided a reassuring confirmation that both countries are keenly aware of the need to cooperate on this front, with the US making amends for the excesses of the past, and China backtracking from its previous aggressive statements challenging the USD’s dominant role.
There is currently no viable alternative to the USD as main reserve currency, and we should bear this in mind whenever new bellicose statements and revolutionary proposals hit the wires. The IMF’s Special Drawing Rights are not a currency but a unit of account; China’s renminbi is not a convertible currency; and plans for a monetary union in the countries of the Gulf Co-operation Council have collapsed over the choice of location for the single central bank. The EUR remains therefore the most credible alternative, but even the single European currency seems fated to play second fiddle for quite a while given the underlying structural weaknesses, including the increasing fragmentation of the euro area sovereign bond market. The dollar is backed by the largest world economy, and USD-denominated asset markets are the deepest and most liquid. Its predominance will weaken over time as the balance of the global economy shifts towards the largest and fast developing emerging markets—but this process is measured in decades, not months.
Meanwhile, the ECB has watched EUR-USD appreciate by some 7% since the last Governing Council meeting—presumably with mixed feelings. A stronger euro is bad news for exporters, and Germany’s growth model is still firmly export-oriented; while export performance depends much more on external demand than on the exchange rate, FX appreciation at a time of still subdued global trade is not welcome news in this regard. On the other hand, euro appreciation helps offset the ongoing rise in oil prices.
On balance, the stronger EUR should come as a relief to the ECB: it offers some insurance against future inflationary pressures and, more importantly, can be read as evidence that the ECB remains more prudent than other major central banks in its policy response.
German Chancellor Angela Merkel however was not sufficiently reassured by the euro’s strength: in statements reported in today’s press she blasted the Fed, dismissed the BOE, and criticized the ECB’s decision to buy covered bonds, which she characterized as bowing to international pressure—thereby pre-emptively accusing the ECB of lack of independence just as she brought to bear unprecedented political pressure. Mrs. Merkel’s attack was impeccably timed, coming on the eve of the ECB’s policy meeting and of elections for the European parliament, and against the background of improving growth indicators.
I do not believe that Mrs. Merkel’s criticism will have any impact on the ECB’s decisions or statements tomorrow. I still expect the ECB will remain non-committal on possible extension of the asset purchase program, reiterating that nothing has been decided yet beyond what officially announced; it will reiterate that the refi at 1.0% is appropriate and that further moves are not ruled out ex ante but will be data-dependent. Our baseline is still that rates will remain unchanged for the foreseeable future, with a meaningful chance (20- 30%) of another rate cut should inflation expectations gap down. The updated staff projections should not bring any major surprises—and since Mr. Trichet has already clearly indicated that probable revisions were already factored into recent policy decisions, the new forecasts should be neutral in terms of policy implications. We expect that GDP growth will be downgraded to about -4.5% this year and no growth in 2010; on inflation, we expect the new forecasts to confirm the medium points of 0.4% and 1.0% for this year and the next, with the wider output gap and higher oil prices vs. three months ago broadly offsetting each other.
Recent statements have confirmed that there is an extremely lively debate within the ECB’s GC, with members holding very different views on whether further easing is appropriate, and whether it should be implemented by cutting the refi below 1.0% or by expanding the scope and size of the asset purchase program. At this stage different views are fully justified: the macro outlook is less clear-cut, and quantitative easing is fraught with difficulties in the Eurozone so that further policy moves become increasingly difficult. I still believe further easing is warranted, but I see internal debate as healthy rather than a worrying sign of potential paralysis.
Mrs. Merkel’s emphasis on the exit strategy was entirely correct but extremely unhelpful. The ECB is already well aware that unwinding the extraordinary policy stimulus delivered across the world will be the biggest challenge for policymakers, and that getting the timing and speed of the unwinding right will require a lot of skill, sang froid, and luck. Last month’s decision to initiate asset purchases was accompanied by a very clear commitment to withdraw the stimulus in a timely manner; the signal was that the ECB is not getting carried away by the market’s “green shoots” enthusiasm, but will not hesitate to reverse course once it is convinced that a recovery is taking hold.
Overall, I expect that the ECB tomorrow will confirm the prudent stance outlined a month ago: signs of economic stabilization are encouraging, but the growth outlook remains extremely uncertain and fragile; the door remains open to further monetary and credit stimulus if and when necessary, but the current stance seems appropriate at the moment; and the exit strategy will be implemented quickly and decisively as soon as possible, with a view to safeguarding medium-term price stability.
