US Dollar faces worst credit crisis since the Great Depression

Foreign Exchange Currency Outlook : The Fed statement will be released at the usual time of 2:15 pm ET today and we will all be glued to the radio or TV to hear it. Nobody expects a rate change but everyone wants to hear some perspective on how the Fed sees inflation. This is measured by how many members dissent and prefer a US Interest rate hike. Bloomberg writes that Bernanke may “need to sound tougher on inflation to avert the sharpest public disagreement among policy makers in more than a decade. The fastest inflation in 17 years adds to the risk that three members of the Federal Open Market Committee will dissent for the first time since 1992. Gary Stern, president of the Fed's Minneapolis bank, and the Philadelphia Fed's Charles Plosser joined Dallas's Richard Fisher since the last meeting in June in calling for an increase in rates to limit price increases. The trio wield more clout than usual because two seats assigned to Fed governors on the 12-member panel are currently vacant. That means Bernanke must craft a consensus that's responsive to the their inflation warnings while still heeding tumbling housing prices, a faltering economy and the worst credit crisis since the Great Depression.”

We agree that three dissents would be a lot and could be seen as a challenge to Bernanke’s authority. Remember, this was one of the main reasons that Paul Volcker resigned as chairman—he felt the Board should let him have the final say. We say this is almost certainly not a crisis in the making but it may roil the bond market. In the end, two dissents is probably what we will get and that will be digestible.

The recent economic numbers are not adding to clarity. The Q2 GDP version of PCE has a slight drop while the income/spending report version yesterday for the single month of June has a rise. Does the Fed see a contracting economy as a remedy for inflation? After all, there’s nothing it can do about the price of oil perniciously wending its way into consumer behavior. If the Fed thinks inflation is caused mostly by commodity prices increases that will iron themselves out (chiefly via reduced demand), then it has no incentive to raise rates. In fact, the Fed may be seeing incentives to cut, such as the desire to keep banks profitable and if not profitable, at least liquid and solvent. Thus a refusal to change rates can be viewed as hawkish.

While the Fed is the single most important institution in the world, let’s be honest and admit that the level of the US dollar exchange rate has nothing to do with monetary policy today and everything to do with the price of oil. Now that it has fallen under the old low from June, it’s wrong to say we cannot see a trend. Of course we can see a trend—we just need more confirmation of trendedness. The 10-day moving average is under the 20-day—there’s a confirmation of sorts. Better would be meeting the next historical lows ($110.30 from May 1 and $98.65 from March 20).

As an aside, those who favor alternative energy should be ruing the current downward trend in the price of oil—it removes incentives to find a fix, and fast. It also has the side-effect of reducing the political conflict between those favoring offshore drilling and those opposed. We say the knee-jerk “drill, drill, drill” of the tiresome Kudlow and his ilk is a dollar-negative. It’s far more dollar-positive for the US to be investing heavily in energy alternatives—it creates jobs and puts American innovativeness (and idealism) on parade as well as reducing stress on the environment.

In any case, we see the correlation of the US Dollar and oil as continuing. It’s very high, about 90% (depending on what timeframe you use). If we imagine that downward trending oil will get grabbed by the technical crowd, we can expect a retracement of the price rise by some pre-ordained amount, like 50%. Let’s say oil took off in Oct 2007 when it surpassed the old high from July 2006 at $78. A 50% retracement off the highest high of $143 is $112, and that is also near the bottom of the current upward sloping linear regression channel. It is therefore a perfectly reasonable forecast. (Note that $143 is the high for the current contract. At the time, the then-front month contract hit a high of $147.90 on July 11.)

It’s also only $7 away from the closing price yesterday, implying the move may be ending soon. In short, we would need to see oil go under the channel and under $100 to get a truly heavy-duty new trend instead of only a retracing trend. By this definition, we say we do indeed need to surpass the old low from March at $98 to be certain of a downtrend. But in the meanwhile, lower prices should be dollar-friendly in the extreme.

Conversely, if something evil happens and oil does a U-turn back to the recent highs,

the dollar will fall off a cliff.

Can it be that simple?

Yes.

Bye for Now

Barbara Rockefeller

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