Europe - recession / US - no recession

Foreign Exchange Currency Outlook :

The perception continued to hold the imagination that the ECB will be cutting rates early next year. Lehman, for one, says the nearly unprecedented rise in the US dollar (second best in 35 years of floating rates on the Fed dollar index basis) will keep going. Lehman sees the euro at 1.43 by year-end and 1.40 by the end of Q1 next year. Since we are already under 1.4600 this morning, we’d say 1.43 will come faster than year-end, and maybe 1.40, too—but not because it’s realistic to think the ECB will cut.

We have no reason to believe the ECB will cut rates. Trichet and others, especially the influential BBK chief Weber, have repeatedly said “single mandate” and that is inflation. Growth doesn’t come second—it doesn’t enter into it at all. With some unions belligerently demanding catch-up money under inflation, the boogey-man of second round effects is no longer a rhetorical trick—it’s real. Theoretically, the ECB couldn’t or shouldn’t cut to help the financial sector, either, like the Fed. If the ECB is stubborn, as we suspect, we could see Europe sliding into recession.

Growth counts in the currency market. Despite all the problems in the US economy today, including the prospect of another year of housing price declines and additional financial sector failures and/or bailouts, we still are not going to see two quarters of flat or contracting growth. The recipe of “Europe--recession/ US--no recession” is euro negative and dollar friendly. You don’t need to postulate an ECB rate cut (or a Fed rate hike) to get this outcome. Growth alone suffices. Note that the IMF is said to be near to cutting its global growth rate from over 5% last year to 3.9%, a deeper cut than expected.

Meanwhile, the Fed is between a rock and a hard place. We guess it would like to raise rates to fight inflation and to normalize (getting a positive real rate of return for investors as well as giving banks a chance to make an honest dollar), but feels it cannot because it might destabilize the financial sector. Besides, to hike now would be to repeat the mistake of the early 1930’s. All the same, Bernanke gave a clue at Jackson Hole—we are lucky to be getting a drop in commodity prices and a rise in the dollar. If these developments continue, economic recovery comes along in their wake, and with less inflation, to boot.

But here’s the rub—Bernanke, like all other government officials, doesn’t believe in forcing market prices to go in the desired direction. Most professional economists in the US say “let the market decide.” To do otherwise—to engineer prices and manipulate markets—is to risk unforeseen and undesirable consequences. It’s also to be socialistic or pinko in some way. To tar all government intervention as pinko is dumb, but we have a long tradition in the US of seeing things that way, a bias that reached full bloom under Reagan. It’s poppycock, of course. The government intervenes in thousands of ways every day in every sector by choices made or not made in its own behavior. The government is the single largest actor on the economic stage, and that’s not even counting tax policies.

For Bernanke to say we got lucky with oil and the dollar is a bit scary. The implication is clear that he would not (for example) advise opening up the strategic reserve to ensure oil speculators keep getting driven out, or any other policy initiative that benefits the dollar. Probably the only initiative he would support politically is greater fiscal prudence, which would indeed be dollar-friendly. In sum, the dollar is the plaything of fate and not something the Fed or the government should “manage.”

This is the environment going into the election. The Democratic Party convention started yesterday, full of idealism and woefully short on real or coherent ideas. We political junkies enjoy this kind of thing but it’s hard not to see that it’s mostly hot air, self-congratulation, and nostalgia (not one but two Kennedy’s). This is a weak position against the winds that will blow from those nasty, mean-spirited Republicans. The election matters to the US Dollar not only because McCain will probably worsen the fiscal mess Bush is leaving behind, but also because nobody really knows how much Obama will spend and on what, or whether certain kinds of spending will even be possible (health care).

The world is not watching yet but it should.

The economy counts more for the US Dollar right now, but a political effect is not out of the question.

Bye For Now

Barbara Rockefeller

Best Exchange Rates - IMS Foreign Exchange