the US dollar is the best of a bad lot

Foreign Exchange Currency Outlook : One Currency analyst in the FT said sentiment is turning toward the idea that “the US dollar is the best of a bad lot.” This is a somewhat insulting version of the FIFO idea, that the first to enter crisis is the first to emerge from it. A key aspect of this version of events is that the Fed may not have rate hikes on its mind, whether to normalize or to fight inflation, but the ECB will be forced to cut interest rates to boost growth by Q1 next year.

The more we think about this line of thinking, the less we like it. For one thing, not every country that goes into a crisis does emerge from it. Think Argentina or Russia. The US is a special case, of course, but even to put it in the same company as other “developed” countries in Europe or Japan is wrong. Both the private sector and the public sector in the US act far faster and with bigger initiatives than elsewhere, for one thing. While the crisis may be less in other places, like Japan, their recovery will trail the US by a long margin. Japan barely came out of a decades-long deflationary slump before the newest crisis. There is nothing inevitable about the course of economic cyclicality.

We have been here before—the US coming out a cyclical turndown (and note that we haven’t seen that yet) while the rest of the world suffers a hangover for a considerably longer time. The longer the US problem, the longer the other guys’ recovery. But there’s a fly in this ointment and it’s named BRIC. Brazil, Russia, India and China have the economic heft to overwhelm US effects on other economies. We already saw China and India siphoning direct investment away from the US, and emerging market demand generally causing the oil price spike. One estimate has it that all the increase in demand for energy comes from emerging markets, which subsidize it heavily. This is a transfer of wealth from one set of emerging markets to the oil producers, and oil producers don’t give all of it back in the form of trade or investment.

So far the US is a beneficiary of this, but the US is hardly out of the woods on financial sector woes. Global investors can still be spooked by developments in the US. This week we get additional housing sector data that bears directly on the health of US financial institutions. If investors start disliking the US and the dollar gain, cui bono? We honestly don’t know.

Britain is in the soup.

Europe is hiding problems.

Maybe Australia and Canada again on commodities alone.

Bottom line—it’s not a straight line out, for anyone.

Another reason to dislike the FIFO scenario is that the policy goals of the two key central banks are different. The ECB cares only about inflation. To say it will be “forced” to cut rates to goose activity is to ignore the nine years of its existence. To believe in an ECB rate cut is to fail to heed Mr. Trichet and Mr. Weber, too, and to believe in fairies at the bottom of the garden. Unions are already girding their loins for the next wage round, most of which comes in

Q1. Rate cut in Q1? Not likely.

And so here we are back again at the bottom line—and it’s oil. Housing prices and existing or new home sales can be any number, but if oil doesn’t cooperate by resuming and maintaining the downtrend, it won’t matter. Oil is everything. Well, it’s not everything because the economy rolls on at any and all prices for oil, but for the US Dollar trend to secure its place as a true multiyear trend, oil simply has to keep falling. It’s as simple as that. We need to watch demand from China and we need to follow the ridiculous stories about Russia, Georgia and other places with names we can’t pronounce.

Sentiment is becoming ever more pro-US dollar as this move proceeds, and that’s nice but it can’t be counted on. A giant screw-up with Freddie/Fannie, or a big bank failure, could postpone the resolution of the financial sector problem. Several big-time analysts like former IMF economist Rogoff have warned about additional failures, including among regional banks. This wouldn’t derail the dollar like oil, but it can’t be dismissed, either. So the dollar has two potential strikes against it, oil and the financial sector. We think the US dollar is safe for the moment, in part of the technical analysis, which are powerful in their own right.

But we need to be alert—the US Dollar is not out of the woods.

Bye For Now

Barbara Rockefeller

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