cautiously optimistic about the US dollar rally

Foreign Currency Exchange Outlook

The July service sector ISM tomorrow is probably the biggest threat to the US dollar ahead of the Fed meeting—it will likely show a small gain (see the WSJ calendar below) but if it’s worse, the dollar could suffer. Services provide a very large chunk of GDP.

For some reason, not much weight is put on personal income and spending, but it perhaps should be. Incomes are expected down 0.2-0.3% after a rebate-fuelled 1.9% in June, with spending rising by about 0.5% (although Bloomberg says the forecast range includes a rise of 0.9%, which would be due to euphoria spilling over from the rebate checks). But as Peter Bernstein says in an opinion piece in the NY Times over the weekend, household earnings and spending are what we have to watch. The consumer is still the driver of the US economy.

If Bernstein writes it, we have to read it, and

if Bernstein is worried, we need to be worried, too.

As for the Fed even talking about rate hikes to tame inflation—forget it. The financial sector is on the edge of the cliff and the Fed feels responsible for not kicking it over. In fact, extending emergency funding plans to January could well be a hint that none of us are smart enough to take—no rate changes until after January, except perhaps an emergency cut. This should be a US Dollar negative but evidently foreign exchange traders give it low credibility. This shows only that they don’t know how banks work. At their core, banks take deposits and make loans (or invest in government paper). The spread is how they make money, and boy, do they need to restore earnings. It is in the Fed’s best interest to keep deposit rates low and asset rates higher, hence the desire for a steeper yield curve.

The sentiment is growing that everybody would really like to cut rates but nobody wants to be first. The ECB has painted itself into a corner with hawkish rhetoric, the Bank of England is at sixes and sevens, the BoJ has to contend with a stimulus package that almost certainly will fail, and the Fed would really rather do nothing for a while until the financial sector calms down—rate changes are only a distraction at this delicate moment.

That pretty much leaves the Reserve Bank of Australia and perhaps the Bank of Canada to take a leading role… the RBA is given only about a 30% chance of changing rates this time, but may make comments cementing the idea of a rate cut next time out. The rate cut idea is by no means universal yet, but we imagine it could gather momentum. Even if the ECB is not seen as being able to cut while inflation is so high, Trichet can decline to use the word “vigilance” or otherwise signal a more relaxed tone. If so, traders will sell euros as it gets another leg knocked out from under it.

We remain cautiously optimistic about the US dollar rally.

Bye For Now

Barbara Rockefeller