Dollar's Dive Depends on Fed Zigging as ECB Zags: Mark Gilbert
By Mark Gilbert
Nov. 30 (Bloomberg) -- Combine faltering U.S. growth with a robust European economy, diverging monetary-policy outlooks for the two regions, and maybe you have an explanation for the dollar's precipitous decline in the past week. Maybe.
The U.S. currency dropped to a 20-month low of $1.3218 against the euro this week, down from about $1.28 last week. The British pound now buys about $1.95, up from $1.72 at the start of the year. Even the Japanese currency has managed to strengthen, to about 116 per dollar from as weak as 120 yen a month ago.
While dollar bears are rejoicing, it is hard to isolate a trigger for the sell-off, which began while the U.S. was slipping into its annual tryptophan-induced Thanksgiving coma. It seems likely, though, that further dollar weakness depends on Mr. Market's interest-rate forecasts coming good.
A year ago, economists were predicting that 2006 would conclude with the benchmark U.S. interest rate at 4.75 percent. Instead, the Federal Reserve has cranked borrowing costs up to 5.25 percent. The most recent surveys suggest that the next move will be a zig back down to 5 percent.
In Europe, the consensus calls for the European Central Bank to zag twice more. Economists see the Frankfurt-based institution raising rates when it meets next week and again in the first quarter of 2007, pushing its benchmark lending rate to 3.75 percent from 3.25 percent currently.
History Lessons
This is the first time since the single currency's 1999 introduction that borrowing costs in Europe are heading higher at the same time as U.S. rates may be poised to decline. The currency market, though, has a mixed record when it comes to paying attention to such differentials.
The last time U.S. and Europe diverged this way, with European money-market rates rising while U.S. deposit rates decreased, the dollar gained against the euro's predecessor, the European currency unit.
In October 1990, the Fed embarked on a series of reductions that cut benchmark borrowing costs by 2.25 percentage points in about six months. In the same period, Germany's Bundesbank tightened by 1.3 points. Nevertheless, the U.S. currency strengthened to $1.20 per Ecu from $1.37.
A similar thing happened in the first four months of 1995. U.S. borrowing costs climbed to 6 percent by April 1995 from 4.75 percent in November 1994, while German interest rates declined to 4.5 percent from 4.85 percent. The dollar weakened to about $1.33 per Ecu from $1.22.
Record Low
The dollar's trajectory last threatened to take it into freefall at the end of 2004, when it dropped to a record low of $1.3666 on Dec. 30. The front cover of the Economist magazine at the time featured a Chinese silkworm chowing down on a greenback.
At that time, the Fed was still in tightening mode, the ECB looked more likely to cut rates than raise them, and the Bank of Japan was still battling the demons of deflation with a 0.15 percent benchmark rate. By February 2005, the dollar was back to about $1.28, and by June 2005 it was at $1.22.
Fed Chairman Ben Bernanke appears to be trying to damp expectations for lower U.S. rates. ``A failure of inflation to moderate as expected would be especially troublesome,'' Bernanke said Nov. 28 in his first speech on the economy in four months. ``In the case of inflation, the risks to the forecast seem primarily to the upside.''
Half-Hearted Rally
The dollar barely budged, though. Even yesterday's revised figures showing the U.S. economy expanded at an annual pace of 2.2 percent in the third quarter -- faster than the 1.6 percent estimate released by the Commerce Department in October -- failed to spur the U.S. currency.
The six-day rout that began on Thanksgiving Day knocked 2.7 percent off the dollar; yesterday's rally recouped about 0.3 percent by the time the U.S. stock market opened, one hour after the gross-domestic-product figures were released.
European officials are struggling to find a way of talking the dollar down from its ledge. They have been claiming for months that the euro area has acquired immunity from any U.S. economic slowdown because of the diminishing importance of trade flows between the two regions. That makes it difficult to start bleating now about the currency needs of European exporters.
Treasury Secretary Henry Paulson is sticking to the official U.S. mantra, saying on Nov. 28 that ``a strong dollar is clearly in our nation's best interest.'' It is becoming increasingly hard to reconcile that claim with the U.S. currency's decline of more than 30 percent against the euro in the past five years.
Central bankers are programmed to see inflation lurking in the economic shadows. That means borrowing costs have a tendency to overshoot on the way up as policy makers act more aggressively than traders or investors say is warranted. As Bank of England Chief Economist Charles Bean said in an Oct. 24 speech, central bankers ``err on the side of caution'' when setting rates.
So what next for the dollar? Betting on higher ECB rates next year is likely to be a winner. Betting that the Fed will cut rates in the next few months, though, seems riskier. So if that's your reasoning, you might want to think twice before you sell another dollar.
(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Mark Gilbert in London at |
