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Dollar Continues to Rally: What is Behind the Move?

Thu, Oct 23 2008, 07:18 GMT
by Kathy Lien

GFT

Dollar bulls continue to take the markets by the horns, driving the British pound to a 5 year low and the Euro below 1.28. Deleveraging and risk aversion have been the primary catalysts for the strength in the low yielders (US dollar and Japanese Yen) but currency bets gone wrong, repatriation and the fears of weak growth in Europe have also fueled the rally.

Although earnings from US banks has been everyone's main focus, European banks who will also be reporting earnings soon and they could face some serious losses as well, especially the ones that have recently received assistance from their local governments. Liquidity problems are usually synonymous with major balance sheet problems for banks. In the corporate sector, Citic Pacific and Latin American companies will not be the only ones to suffer losses due to currency bets gone wrong as they try their hands in the FX markets. The outlook for the European economies is very grim and when combined with risk aversion in the financial markets, it translates into severe weakness for the Euro and British pound against the US dollar.

The Dollar Could Rise Another 5 Percent

After injecting a massive amount of liquidity into the financial markets, central banks are finally seeing their desired reaction as LIBOR rates fall and lending becomes more fluid. In the long run, this should help to stabilize the financial markets and restore confidence, but in the short term, there could be further dollar strength. Given that the Purchasing Power Parity levels for the EUR/USD and GBP/USD are approximately 1.15 and 1.56 respectively, the dollar could rally another 5 percent before the dust settles. Furthermore, the Fed has made another announcement in an attempt to stabilize the financial markets. They changed the interest rate that they are paying on excess reserves from 75bp below the Fed funds rate to 35bp. The announcement itself was not a big surprise, but the timing was. They have could have made this announcement next week when they cut interest rates, but their decision to do so now rather than later suggests that they may be preparing for a smaller rate cut next week. Unless the Federal Reserve wants to take interest rates to zero percent, each quarter point rate cut from here on forward may need to be rationed. The market is still pricing in a greater chance of a 50bp rate cut, but the Fed will not be alone in feeling the need to be conservative; the Bank of Canada certainly felt this way when they cut interest rates by only 25bp this week.

How Much Will Dollar Strength Hurt Exporters?

On a trade weighted basis, the US dollar has appreciated more than 18 percent since July. The typical notion is that dollar weakness helps US exporters while dollar strength hurts them but globalization has actually changed this dynamic with some exporters now benefitting from dollar strength. The key is in their expenses because if they manufacturer abroad, dollar strength reduces their foreign expenses. A perfect example is Caterpillar Inc, the world’s largest manufacturer of construction and mining equipment. In the third quarter, they actually recorded an exchange rate gain because the strength of the dollar reduced their net liability position in Europe. Google on the other hand took a big hit from dollar strength. Although the company does not export anything, more than 50 percent of their revenues come from outside of the United States. As the dollar appreciates, it reduces the value of their foreign earnings. The same is true for Yahoo. Therefore just because a US company is export driven does not mean that the dollar’s recent strength will be a drag on earnings. At the same time, a multinational service oriented firm is just as vulnerable to currency fluctuations.

Global Economic Summit Scheduled for November 15

The Global Economic Summit will be held on November 15 in Washington. The continual weakness in the equity markets and heightened risk aversion will pressure world leaders to come up with new ways to deal with the global economic crisis. Whether the leaders deliver remain to be seen, but the original goal of the meeting is to put more regulation and surveillance in place to prevent a repeat of the crippling financial crisis. Gordon Brown of the UK is in favor of strengthening the surveillance role of the International Monetary Fund (IMF) and giving them the power to coordinate global responses. Large and radical change are expected leading some people to call this meeting Bretton Woods 2. For those who are unfamiliar with Bretton Woods, 44 Allied nations gathered in Bretton Woods, New Hampshire to set up a system of rules, institutions and procedures to regulate the international monetary system towards the end of World War 2. The core of the Bretton Woods system centered around the obligation of each country to fix their currency to the US dollar, which was fixed to gold. Although the major nations of the world may not be looking to bring back those pegs, they do want to return to the discipline that governed the markets in the first Bretton Woods.

Published on  Thu, Oct 23 2008, 07:18 GMT