The Hindu Business Line : Central banks' impotence presages weaker dollar

With central bankers no longer as powerful as they once were, the dollar will remain weak. They won the war against price stability and now they are fighting to defend, if not fuel, asset price inflation, because they fear the consequences of ending it, says V. Anantha Nageswaran.

I SHALL begin this column with three seemingly disjointed statements. First, on February 28, this column concluded that the day of reckoning for the American dollar was drawing closer. Subsequent dollar movement mocked at this conclusion. The dollar has broadly strengthened against the euro and the yen. Second, Stephen Jen of Morgan Stanley now has company. Third, two weeks is a long time in financial markets.

Chorus on dollar recovery gains in strength

This column will try to make sense of all the three statements. Stephen Jen is Global Currency Strategist for Morgan Stanley. He has been predicting an appreciation of the dollar since 2004. The dollar may have had its moments of strength but, on balance, it continued to weaken against other major currencies in 2004, defying his call for a firmer greenback. Now, not only has the currency begun to respond to his call, he has been joined by other Wall Street firms. Credit Suisse First Boston forecasts the euro to be around $1.15 in a year's time, down more than 10 per cent from its current level of around $1.29.

Their rationale is that the yield support for the dollar and the relative economic strength of the American economy would prove to be an irresistible combination for investors — public or private.

UBS is hedging its bets. It is ready to jump into the dollar strength bandwagon as soon as it sees more money flood into American equities, notwithstanding its oft-repeated calls for a weaker dollar, based on ever-growing current account deficit. Goldman Sachs, Deutsche Bank, HSBC Bank, Merrill Lynch and Citigroup are still holding out for a weaker dollar.

To cut to the conclusion, I remain unconvinced that glory days for the dollar are round the corner. The strength of the dollar in recent days could simply be the odd counter-trend rally that has punctuated the long downtrend that began in 2002. Of course, there is no knowing whether this rally would end next week or in six months. Nonetheless, I would be quite persuaded to look at currencies such as the euro and the pound-sterling if they weaken a little more from their present level.

Why am I adamantly dollar-bearish when the Federal funds rate is already at 2.75 per cent — a not-so-insignificant 75 basis points higher than the policy rate of 2.0 per cent set by the European Central Bank (ECB)? Further, the ECB in its latest policy setting meeting, that took place last week, sounded less aggressive than what market participants had expected.

September Euribor interest rate futures had risen nearly 15 basis points in price in the last two weeks, indicating that market participants have taken note of not only weak economic data in the Eurozone but also of the ECB's inability to act as aggressively as it sounds or would like to.

Indeed, there is an outside possibility that the ECB will be forced to cut rates in the second half of the year. This, if any, should bolster the rate differential in favour of the dollar. Then, why am I still adamant that the US dollar strength is ephemeral?

Central banks show their `bad hand'

The dilemma of the ECB is the dilemma of the Reserve Bank of Australia and is also the dilemma of the Federal Reserve. Just last week, the Reserve Bank of Australia (RBA) left its interest rate unchanged after increasing it the previous month to 5.5 per cent. Many had expected it to follow through with another quarter percentage point increase. The RBA refrained and the very next day, the Australian labour force survey showed that the economy generated eight times more jobs in March (around 56000) than what the market had predicted (around 7000), mocking the decision of the central bank not to walk its tough talk.

The US Federal Reserve chairman in February described the low bond yield a `conundrum'. After that, the 10-year Treasury note yield backed up to a high of around 4.68 per cent, the day after the March meeting of the Federal Reserve Open Market Committee (FOMC).

Since, then it had climbed down to 4.48 per cent. Indeed, it is now a few basis points lower than the level on the eve of the FOMC meeting in March. Admittedly, some recent labour market data were on the softer side. However, it is arguable if this merited a slide-back in the yield to 4.48 per cent.

After all, short-term interest rate, inflation, output, employment and wage indicators have come a long way since the 10-year Treasury note yield plumbed to a low of 3.1 per cent in June 2003. Yet, the bond yield is up `only' 135 basis points.

FOMC officials have been talking up the inflation risk in the last few days and the need to raise the Federal funds rate more `vigorously'. Yet, the bond market is unfazed. I guess that the bond market is calling their bluff.

It is possible that the bond yield re-tests the recent intra-day high of 4.68 per cent. It is equally possible that it would fail and retreat. The Fed may not be in a position to raise rates above 3.5 per cent, as it would be `fearful' of the impact on the economy and the highly leveraged American consumer.

Now, you would understand why I wrote in the beginning that two weeks is a long time for a fund manager.

In my last column I had mentioned that the market expectations for the Federal funds rate had not reached pessimistic levels and that there was room for those expectations to rise. Consequently, I had predicted that the long bond yield had more room to rise too. Yet, the pusillanimity of the ECB and that of the RBA makes a very powerful point that cannot be ignored.

If central banks that have a pure inflation mandate cannot go beyond the rhetoric, how can it be possible for a more politically sensitive Fed with mandate to promote full employment and price stability?

No central bank is able to go beyond the rhetoric because they have all become prisoners of their own interest rate policy decisions of the last few years.

In the absence of vigorous (real) investment spending which would boost GDP growth and raise the real return in the economy thus raising real borrowing costs, there is every risk of pushing over-indebted households into insolvency with rate increases.

With the IMF warning of a permanent oil price shock — citing both demand increases and supply constraints — central banks are unable to raise borrowing costs for fear of adding to the dampening effect of dearer oil, on economic activity. Hence, the recent aggressive speeches by the Federal Reserve officials are just that.

They are an attempt to substitute monetary policy decisions with rhetoric so that central bankers can vicariously satisfy themselves that they are doing their jobs.

US trade deficit has only one way to go

Now, it is possible to connect the first sentence as well. If US interest rate expectations are pared back because of slower growth, then it diminishes the yield-support argument for the dollar.

But is slower growth not good for the dollar as it would put a lid on the current account deficit? Well, not so fast. America might grow at a slower rate than expected but other big nations are growing even slower too. Japanese growth has faltered, as has European growth.

With the price of crude oil firmly entrenched above $50 per barrel, stronger American growth would keep American trade balance firmly in the deficit and rising. Investors may get a reminder of this as early as on Tuesday when the American trade deficit report for February is released. If the Chinese trade surplus figures for January and February are any indication, the risk to the February deficit report is on the higher side of consensus prediction.

Whenever this fact sinks into the collective consciousness of the market, the dollar would resume its decline with its uncertain consequences.

It is ironical that the era of fiat money that vested central bankers with god-like powers (creating money out of thin air) has now chained them from exercising their power not to create such easy money. They won the war against price stability and now they are fighting to defend, if not fuel, asset price inflation, because they fear the consequences of ending it.

Until they muster the resolve to end it or some external shock ends it, the bubble would live on — in New York, in Florida, in Shanghai and in the bond market trading pits.

Until then, fund managers would have to accept risking their careers by warning and by being positioned against market risk, for they are betting against the fact that the interests of the investors and the broader financial world are fundamentally aligned with long positions in paper assets and their rising values.

Tailpiece: In the February 28 column, I had examined and made light of the argument that American corporate profitability mattered more than the current account deficit. For a more formal and elaborate counter-response, congruent with my views, read Brad Setser's note on the topic by clicking at: http://www.roubiniglobal.com/setser/ archives/2005/04/mckinsey_says_t.html

(The author is founder-director of Libran Asset Management (Pte) Ltd., Singapore. The views are personal. Address feedback to van@libranfund.com)

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