The Hindu Business Line : US dollar resumes its long decline

As the US either slides into moderate to weak economic growth with little return for dollar asset holders either from bonds or equities, the dollar has to weaken significantly in the years ahead. That makes the case for gold rather compelling at current prices. Sceptical investors may regret their indecision, says V. Anantha Nageswaran.

ON FRIDAY, the US employment report for May was released. For the record, the economy created 248, 000 jobs in the last month. Further, the number of jobs added in April and May was revised higher. Nearly a million jobs have now been created in the last three months. It is an impressive performance. No matter what one has to say about the monetary policy of the Federal Reserve or the fiscal policy of the Bush administration, the American economy remains the world's most flexible and dynamic when it comes to job creation.

However, the report for May was similar to that for March. It was impressive at first glance but not so when takes a closer look. The duration of unemployment — number of weeks some one remains unemployed after losing his/her job — lengthened. The Economic Policy Institute (EPI) points out that "the share of the unemployed out of work for at least half a year remains at recessionary levels: 21.9 per cent in May, an increase of 0.5 per cent from a year ago."

An alternative measure of unemployment takes into account the fact that some workers could have left the labour force involuntarily (unable but not unwilling to find a job and hence stopped looking for a job) or may be holding a part-time job while remaining willing and able to take up a full-time job. That measure of unemployment edged back to 9.7 per cent from 9.6 per cent in April.

Diffusion indices of employment showing the proportion of industries that add jobs relative to those that shed jobs also dipped slightly in May. Average hours worked remained unchanged in May from April. It is unusual to find average hours worked not expanding when hiring picks up.

The EPI observes: "On average, the industries that are expanding as a share of total employment pay lower wages than those that account for a smaller share of the total. Averaging over the past three months, and comparing this year to last year, industries expanding as a share of total employment pay on average 13 per cent below industries contracting as a share." Hence, the annual growth in wages is running at 2.2 per cent, just around the rate of inflation.

EPI's Josh Bivens makes an interesting observation about the growth in profits and wages since the recession ended: "Corporate profits have risen 62.2 per cent since the peak, compared to average growth of 13.9 per cent at the same point in the last eight recoveries that have lasted as long as the current one. This is the fastest rate of profit growth in a recovery since World War II. Total labour compensation has also turned in a historic performance: growing only 2.8 per cent, the slowest growth in any recovery since World War II and well under the historical average of 9.9 per cent."

According to the University of California, Berkeley economist Dr. Bradford de Long, high labour market slack, by keeping a lid on real wages, has become a tool of the class war in America.

I bet that the payroll figure for the month of May will not be bettered for the next several months. Global expansion might already have peaked under the persistently high oil price and diminished risk appetite. Now that OPEC has decided to raise production in the next few months, that card has been played and the risk hence is skewed towards higher and not lower prices.

The drop in the crude oil price below $40 per barrel is unlikely to last very long.

Overall, the labour market in America appears healthy under the circumstances but one that may already have reached peak health with no further scope for improvement.

Hence, the reaction in the financial markets to this report has been quite interesting. Stocks rallied, bonds sold off lightly, the dollar dropped and gold perked up. This is in contrast to the reaction that the March and April reports provoked. Then, dollar surged, gold, stocks and bonds dropped sharply.

Stock markets may have thought that the American economy had hit the sweet spot: Robust jobs growth with little wage pressure on costs and hence inflation. The bond market was nervous but not neurotic on Friday.

However, the decline in the foreign exchange market, the most liquid and international of them all, suggests that investors do not anticipate the interest rate support for the US dollar that they anticipated when March and April employment reports were released. That accords with my hypothesis that the May employment report May have been the best for a while.

If the US dollar resumes its long-term trend decline, the question is against which currencies? We shall turn to two recently released current account reports for an answer to this question. Chart 1 shows the trend in the Canadian current account deficit in the last fifteen years and Chart 2 that of Australia.

Australian dollar risks

The Canadian current account balance has steadily moved into surplus in recent years. In contrast, the Australian current balance has steadily moved into deficit. The contrast with the former cannot be wider. Australia has been able to finance the deficit easily as investors have bought higher yielding currencies like the AUD given low yields in Japan, Switzerland and the US.

Rising commodity exports to China have also helped to underpin demand for the currency from the macro angle. However, the risks are there. One risk has been the speculative housing market. Early indicators suggest that the speculation in the property market is moderating. Home loans have contracted for the last six months. Data is available until March. However, that does not mean that the home price appreciation has ebbed. Indeed, until the last quarter of 2003, home price appreciation has been running at nearly 20 per cent per annum.

In addition to the above, the current account deficit had widened. It is now running at 6.1 per cent of GDP. I understand that, in a recent private conversation, the Reserve Bank of Australia Governor expressed no concerns over the American current account deficit pointing to the fact that his country had run much larger current account deficit as a percentage of GDP. That was a little disingenuous.

His country is much smaller and whenever his country's current account deficit had gone past 6 per cent of GDP (it has now clocked two quarters above this magical number), the AUD has plunged. The current account deficit of the US, given its $11-trillion economy, means that the funding requirement is much larger. The world is already awash with US dollars. Hence, the US dollar has to weaken substantially for the deficit to either contract or to be financed.

While the risk of a hard landing in the housing market has receded somewhat, it is not out of danger yet. A sharp slowdown in China — it could still happen, this year or next — could rob the Australian dollar of export support leaving it more vulnerable under a consequent higher current account deficit. Any disruption to global growth coming from terrorist incidents causing the oil price to spike higher is an additional source of threat to the economy whose external dependence has risen again. Rising global risk aversion invariably hurts currencies with high current account deficits.

Hence, the Australian dollar, while it remains well supported versus the US dollar because of the wide interest rate differential, does carry some risks.

Canadian dollar opportunities

In contrast to the lingering concerns on the Australian dollar, the Canadian dollar is an oasis of stability. The country enjoys both a current and a budget surplus. The current account surplus, in addition, is rising. The currency has not recovered much against the US dollar and even against the Swiss franc. The Swiss franc appreciation against the US dollar is understandable given its safe-haven status in the uncertain and dangerous global security environment. However, this continues to present us with excellent long-term opportunities. The relatively significant underperformance of the Canadian dollar is attributed to the uncertainty over the election outcome in June.

The Liberal Prime Minister, Mr Paul Martin, has wagered that he would be able to scrape through despite some recent scandals dogging the party. If he fails to win a mandate, despite having brought Canada from the brink of fiscal disaster to fiscal strength in the nineties, the market is likely to view that as a negative outcome. However, that risk is pretty much reflected in the current exchange rate of the currency, particularly against the Swiss franc.

Given the recent all-round Swiss franc strength, not just against the US dollar, it is unlikely that the Swiss National Bank (SNB) would push interest rates higher this year. This writer's view on the global monetary policy outlook must be quite familiar to readers by now. He does not expect monetary policy to tighten (if at all) to the extent that the market has priced in. The risk of policy ease is ever present and rising.

The SNB is likely to stay on hold throughout this year and possibly contemplate aggressive monetary policy easing in 2005. Therefore, it would be appropriate to undertake further Swiss franc financed bond portfolios with significant weights to the Canadian dollar, the Euro and much lesser weights to the Sterling, Australian and New Zealand dollars.

All roads lead to gold

The fact that only the euro and the Canadian dollar seem to offer a fair deal to investors on a risk-adjusted basis suggests that the dollar does not have too many currencies to decline against.

That once again brings us back to familiar ground: The case for gold. As the US either slides into moderate to weak economic growth with little return for dollar asset holders either from bonds or equities, the dollar has to weaken significantly in the years ahead. That makes the case for gold rather compelling at current prices. Sceptical investors would regret their indecision in the years ahead.

(The author is Director, Global Economics and Asset Allocation, Credit Suisse, Singapore. The views are personal. Address feedback to nageswar@singnet.com.sg)

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