We continue to think the dollar exchange rate will come back after this big and abrupt correction, which has by no means proven itself a true reversal

Foreign Exchange Outlook : The Fed funds rate at 1% matches the level of June 2003 and before that had not been in force since the 1950’s. That should suffice to scare everybody, not least because we have no idea what’s next-0.50%, or zero, as in Japan? The Fed is running out of traditional ammunition. Today we must expect Q3 GDP to be a negative number. The Bloomberg survey comes up with a drop of 0.5%. As always, we have to wonder if a lesser drop would be dollar exchange rate supportive and a bigger drop even more sharply dollar-negative. This gets tricky and tangled because a bigger drop implies lower oil and commodity prices, which “should” be US dollar-favorable. The scary rise in commodity prices, especially oil, on the US rate cut is probably doomed. It’s a bad assumption under current conditions to think rate cuts can goose activity and restore growth to its old path. The old path is gone. This should be welcome because we needed to break the circular link between oil and the dollar.

The big-picture reasons to think the US dollar will not reverse trends include that the unwinding of leveraged positions is not over yet. It took about 5 years to establish these positions. Surely it takes longer than a few months to unwind them all. In fact, those who put on carry trades five years ago are not in hot water yet… raising the question of whether they need to get unwound. Besides, there are always some diehards. Even those positions that are not heavily leveraged may get undone. State Street said last week that US investments overseas total $5 trillion. Everyone fell in love with the idea of diversification, but maybe it looks less appealing today, especially in emerging foreign exchange markets.

Another big-picture idea is that US rates are now almost at rock-bottom, while Europe still boasts an overnight rate of 3.75%. As ECB chief Trichet warned, a rate cut next week is a real possibility-and the market thinks more are possible, too, for a total of 75 bp by year-end to 3%. This would give the eurozone an advantage of 200 bp, but in a global recession, higher rates are a drag, not an advantage. Besides, as we have seen, the rate for euros is no longer the key rate. Instead the key rate is the US Dollar rate among European banks, and since they won’t lend to one another, the US Fed is providing the funding, at a premium. In sum, European banks have a trust issue and can get credit only from their own central bank in a currency that the central bank does not issue. This is embarrassing and significantly lowers the status of eurozone institutions both private and public.

We continue to think the dollar exchange rate will come back after this big and abrupt correction, which has by no means proven itself a true reversal.

Faith in the US dollar is based on the same factors as before-the safe-haven bid will return with a vengeance when the next Shock hits. At this point, despite the uneven implementation of the US rescue plan, the most likely location of the next Shock is outside the US.

Buy for Now

Barbara Rockefeller
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