The U.S. Dollar — Is The Tide Turning?
Kurt Brouwer July 31st, 2008
To paraphrase a quote from the late Max Heine (founder of Mutual Shares Fund): “The dollar was so bad it couldn’t go down no more.”
This post from the WSJ’s MarketBeat Blog [emphasis in the original] illustrates how the tide may be turning in favor of the dollar:
Slowly The Dollar Is Winning Converts (Wall Street Journal / MarketBeat Blog, July 31, 2008, David Gaffen)
Suddenly, people aren’t feeling so sour about the dollar.
This isn’t to say that the greenback is on the verge of a charge that will enhance its value against the euro, yen and other major currencies. However, the activity in the foreign exchange markets of late suggests that the knee-jerk interpretation of any and all data as dollar-negative — a view that held sway for months — is no longer operative.
The euro reached a high of $1.6038 on July 15. Since then, it has fallen back, dropping to $1.5591. It’s not exactly a massive move, and doesn’t even push the euro/dollar out of its recent trading range. But it is at the lower end of this trading range, and the reaction in the foreign exchange market to Thursday’s economic data shows that investors are predisposed to think more positively about the dollar.
“You are starting to get a more forgiving attitude to the dollar,” says Joseph Trevisani, chief market strategist at FX Solutions, who says investors are more likely to look at positive developments, “rather than ignoring it and only focusing on the bad news.”
The dollar is stabilizing a bit, in large part because the Federal Reserve stopped cuttings its Fed Funds interest rate. Many people do not fully understand how significant short-term interest rates are for currencies. Trust me, they are critical.
As a sign that times are changing, take a look at this piece from Bloomberg [emphasis added]:
Gross Likes Dollar More Than Euro For 1st Time (Bloomberg, July 13, 2008, Gavin Finch)
…Bill Gross, manager of the world’s biggest bond fund, turned bearish on the euro for the first time since the currency’s inception in 1999.
“We might have hit a point where the euro doesn’t have a lot to stand on,” said Emanuele Ravano, co-head of European strategy in London for Gross’s Pacific Investment Management Co., which runs the $129 billion Pimco Total Return Fund. “The euro is ultimately very overvalued. It could be quite a bit lower at some point in time over the next couple of years.”
I think it is interesting that Gross was so positive on the Euro back when it first came out. By way of historical reference, the Euro fell versus the dollar for the first several years of its existence. It was not until nearly 2004 that it got back to even.
This chart from the St. Louis Federal Reserve Bank makes the point. This chart shows how many dollars it takes to buy one Euro. That number fell for the first years of the Euro’s existence, in large part because U.S. short-term interest rates were going up:
Source: St. Louis Federal Reserve Bank
During the recession of 2001 and the aftermath of September 11, the Fed, under Chairman Greenspan, cut short-term interest rates aggressively. As a result, the dollar began falling and has continued doing so until recently. The article continues:
The euro fell as much as 1.7 percent to $1.5611 in the week following President Jean-Claude Trichet’s comments on July 3 that he had “no bias” on further changes in borrowing costs after boosting the main refinancing rate to 4.25 percent from 4 percent. Before Trichet spoke the currency traded near a record high on speculation the ECB would signal more than one rate increase was needed to tame inflation. It fell 0.5 percent to $1.5857 as of noon in London today, from $1.5938 on July 11.
…As the odds that the ECB will lift rates dwindled, hedge funds sold the 15-nation common currency, according to Zurich- based UBS AG, the world’s second-biggest currency trader behind Deutsche Bank AG in Frankfurt. New York-based Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, said it’s “increasingly confident” the euro will fall.
…The euro is 30 percent overvalued versus the dollar, based on purchasing power parity, according to Newport Beach, California-based Pimco. That’s more than any other currency among the Group of 10 richest nations. Purchasing power parity accounts for differences in the exchange rates of national currencies.
“When a currency gets between 25 percent and 30 percent overvalued it tends” to revert to the mean, said Ravano. The euro may drop to $1.535 from $1.5938 last week, he said.
...”The rally in the euro is over and we’re now incredibly bearish on the currency given the outlook for Europe’s economy,” said Hans-Guenter Redeker, the London-based global head of currency strategy at BNP Paribas SA, the most accurate foreign-exchange forecaster in a 2007 Bloomberg survey.
The euro will slide to $1.50 by the end of the third quarter and $1.45 by year-end, he said. Redeker is more bearish than most strategists. The common European currency will weaken 5.4 percent to $1.50 by year-end, and slip to $1.45 by mid-2009, according to the median of 37 analysts surveyed by Bloomberg.
“At current levels the euro is an awfully expensive currency,” said Stephen Jen, chief currency strategist at Morgan Stanley in London and a former Fed economist. “We see fair value for the currency at around $1.30.”
The Fed’s current posture is that we should not expect any additional cuts to the Fed Funds rate. As a result, the dollar has shown a little strength lately (see Is the Euro Headed For a Fall?). The dollar fell too far versus the Euro in my opinion and that process now seems to be reversing. Currencies fluctuate daily, weekly and monthly, but they also have long-term trends. For the first few years of its existence, the Euro tanked versus the dollar, hitting a low point at which one Euro was worth only 86 cents. That was one extreme. Now, one Euro is worth $1.55 or more. This price represents another extreme. In my opinion, the true relationship between the two currencies should be somewhere in between.
For a fuller discussion of the historical relationship between the dollar and the Euro as well as the British pound, see How Far Has the Dollar Fallen? And Why? — What’s Next?.
- Economy , Geopolitics , Money , Mutual Funds
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