Today’s record lows in the U.S. dollar ($1.50805 vs. EUR), record highs in gold ($965 per ounce) and record highs on oil ($102.08 per barrel) mark a key tipping point in currency markets as traders further downgrade the U.S. currency to a low yielding asset. Rather than subscribing to the notion that the Federal Reserve’s aggressive rate cuts are a positive for the U.S. economy and hence the U.S. currency, or postulating the notion that European and other economies are months away from joining the U.S. into pain mode, the greenback is being damaged across the board on the notion that the ultra low interest rates, at the expense of escalating inflation, is the only way forward to prevent further spreading of the U.S. recession.
The tipping point of the latest highs in gold and oil clearly emerge from yesterday’s slide in the U.S. dollar when a combination of back-to-back unexpected increases in Germany’s IFO business survey and dovish remarks from Federal Reserve Vice Chairman Donald Kohn, one of the Federal Reserve’s most credible figures, downplaying the durability of inflation risk at a time when price pressures have picked up in speed on the consumer and producer levels.
The consequences of pronounced dollar declines are the following:
Broad declines in the U.S. stocks and bonds. Although a lower dollar has proven positive for U.S. equities, broad USD selling, such as in early July, and mid November has proven a general negative for U.S. asset markets due to the erosion in the denominated currency.
Fed falls behind both inflation and recession curve. Further increase in inflation through not only a higher oil import bill but falling affordability of other commodities will further constrain the task of Federal Reserve policy makers and place the central bank behind both the inflation curve and the growth curve.
Mideast currency reaction. Despite rising oil prices, the tumbling dollar will further press oil-producing nations in the Gulf to adopt hard decisions about their unsustainable currency regimes, which are pegged to a tumbling dollar. Any comments indicating such intentions will risk exacerbating the currency sell-off as was proven last year. Although a certain complacency has prevailed, suggesting that Gulf nations will not risk eroding the value of hundreds of billions of USD denominated investments, swallowing the pain of devalued holdings is seen as the lesser evil than prolonged erosion of purchasing power and personal incomes to which national governments’ sole solution is salary hikes and subsidies.
Central bank reserve diversification. Currency reserve diversification is not just the subject of Middle Eastern central banks but is also the concern of other central banks accumulating the bulk of their reserves in U.S. dollars. Although IMF and BIS data have shown no marked reduction in U.S. dollar holdings, falling U.S. bond yields and a U.S. dollar coupled with multi-decade highs in the commodity currencies of Australia and Canada will likely prompt central banks to consider diversifying into these currencies.
Dollar remains under pressure after U.S. durable orders fell 5.3% last month, undershooting expectations of a 4.0% decline. Ex-transportation orders fell 1.6% due to a 13.4% decline in transportation marked by a 30.5% plunge in aircraft orders.
Fed Chairman Ben S. Bernanke’s testimony at 10 am EST is expected to reiterate the downside risks to economic growth are the underling concern of the central bank. The key question is whether Bernanke will signal the magnitude of the easing at the March Federal Open Market Committee (FOMC) meeting. In the event that he reiterates Donald Kohn’s comments indicating that growth fears remain the principal priority, then markets will raise the likelihood of a 50 bp rate cut, especially after the latest figures in housing, consumer durables and continued sharp declines in mortgage applications. We expect Bernanke to stick to the “we will do what is needed” mantra, which will open the door for half a point move and trigger broad declines in the dollar.
Kohn’s speech on the economy and monetary policy at 12:15 pm will serve to guide the direction of the markets’ pricing of a 50 bp rate cut next month.
Ashraf Laidi
Chief FX Strategist
CMC Markets US
a.laidi@cmcmarkets.com
