Three Conditions for Dollar Trend Change by D Gilmore

When I read why the dollar is about to bottom and begin a longer-term (sustained) uptrend I can’t help but think it’s a case of Yogi Berra’s deja vu all over again. I should know…ahead of the break of 1.49 in euro/dlr earlier this year I too was waving the dollar has bottomed flag at the NASCAR fleet driven by a bunch of bears. It (a dollar cycle trend change) will come but not now and not easily. One thing that we couldmhave told G7 ahead of its recent meeting last Friday in Washington is that simply wishing dollar weakness away is not helpful…it’s policy steps stupid.
When I read why the dollar is about to bottom and begin a longer-term (sustained) uptrend I can’t help but think it’s a case of Yogi Berra’s deja vu all over again. I should know…ahead of the break of 1.49 in euro/dlr earlier this year I too was waving the dollar has bottomed flag at the NASCAR fleet driven by a bunch of bears. It (a dollar cycle trend change) will come but not now and not easily. One thing that we couldmhave told G7 ahead of its recent meeting last Friday in Washington is that simply wishing dollar weakness away is not helpful…it’s policy steps stupid.

So here are my three main policy steps critical to a major change in trend for the dollar.

1/ The Fed needs to signal and markets believe with some certainty that the easing cycle is over.

2/ The ECB need to signal two-way risk in official rate policy.

3/ G7 needs to conduct coordinated currency intervention.

While any one of the three would cause a significant dollar bounce (correction), all three conditions need to be met before I can again wave the dollar buying flag at the market. Indeed the success of 3/ depends on 1/ and 2/ being in place. However, none of the conditions appears likely in the foreseeable future.

First the Fed made the mistake of painting itself into a corner in August 07 and again October 31 prematurely signalling a pause – hurting its credibility in both instances. Given the US economy is now in or entering recession, the Fed can ill afford to paint itself into a cormer again on easing even with Fed fund 300bps lower than the start of the cycle and real Fed funds rate negative (rate of inflation above the funds rate) and the nominal rate a low 2.25%. In a period of high uncertainty over the economic forecast, surely complicated by the surge in commodity prices and credit crisis, the Fed is in no position to signal a pause in easing without risking its credibility all over again – and that credibility was tarnished until the Bear Stearns solvency backstop and the March 18 FOMC meeting.

The Fed is operating under the assumption the recession/slowdown will be V-shaped…short in duration…out by second half of 2008. But this also is shrouded in uncertainty which Fed’s Yellen alluded to today – it could turn out to be deepr and longer or U-shaped.

Second the ECB is further away from signalling two-way risk in interest rate policy after today’s March inflation revision to 3.6% y/y from 3.5% in the preliminary report…recall the Bank targets less than 2%. This week ECB’s Mersch said the Bank would not be cutting rates this year. Barring a sudden slowdown in the EZ ahead (one that impacts more than Spain, Ireland, Greece and Portugal…yes I see this happening), the ECB is not going to fold under market or US pressure to begin considering a rate cut…not even with the euro above 1.60.

Third, the idea that US and UK officials will embrace currency intervention to support the US dollar before the ECB changes its attitude on rates is unlikely. Indeed confidence in currency intervention as an effective policy tool is at my market lifetime low (1987). The bar for currency intervention is high, very high. And we can all but rule out unilateral intervention. Fundamentals need to change (in favor of) for currency intervention to get even a minute of consideration (outside France and Italy). SO why is currency intervention included as a condition for a turn in the dollar? Because it has made an appearance in every majpr change of trend for the buck that I have witnessed in the last two decades and markets overshoot and need a kick in the shins at extremes. Now if the G7 were to really get its act together it would sell gold when it intervenes…granted a remote possibility…rather than buying spot dollars.

We are months away from these 3 conditions being met and probably closer to 1.70 in the euro and 95 in dollar/yen before the dollar finally turns.

David Gilmore

Foreign Exchange Analytics has it's roots in both the emerging information technologies and the global economy that characterized the last two decades.  As currency transaction volumes soared in the wake of the 1985 Plaza accord, the need for timely concise information on what forces were driving and would drive exchange rates became critical.   David Gilmore was one of a new breed of analyst that saw a void of relevant, market moving... More