Red alert! Greenback in danger
JOHN PARTRIDGE
Globe and Mail Update
Women and children first!
It is time to abandon the greenback because the already leaking currency is about to slam into an iceberg in the shape of a hard landing for the U.S. economy and other perils, foreign exchange analysts at BNP Paribas SA of France warned yesterday in an SOS to clients.
The London-based analysts figure the fall will drive the euro up to $1.40 (U.S.) in the second quarter of next year from the current level of just under $1.33, itself a gain of more than 5 cents since the start of November.
The key piece of evidence they cite for the U.S. economy coming down hard, not soft as markets had initially expected, is that in the third quarter, gross domestic product growth fell “below the crucial 2.0 per cent level to 1.6 per cent, which has historically been consistent with the U.S. economy going on to develop a severe slowdown if not a recession.”
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Among the other reasons they list for bailing out of the buck sooner rather than later are:
They expect the U.S. central bank to cut its benchmark interest rate, currently 4.25 per cent, by 50 basis points in March, and by an additional 100 basis points during the second quarter. The rate will end the year at 3 per cent, they forecast. (A basis point is 1/100th of a percentage point.)
This in turn will cost the U.S. dollar the protection it has enjoyed from higher rates by mid-2007, as U.S. money market rates fall below the average of G10 and euro interest rates, turning the greenback “from a yielding currency to a funding currency,” a change in status that has historically weakened it.
The currency will also come under pressure from a narrowing of bond yield differentials, with that between 10-year U.S. and European bonds, for instance, likely falling to about 25 basis points next year from 77 currently.
Investors are already starting to “show signs of turning bearish” on U.S. bonds, the most important source of funding for the U.S. current account deficit, and this will hurt the dollar.
The U.S. yield curve, currently inverted by about 20 basis points — that is, yields on shorter-term bonds are higher than on long-term instruments — will likely steepen by about 100 basis points. This will encourage foreign investors, and especially Japanese investors, to rehedge their U.S. assets, again putting the buck “under pressure.”
There is a “significant risk” of a sudden unwinding of carry trades — borrowing in a country with low interest rates, such as Japan and Switzerland, to invest for better returns where rates are higher — perhaps “triggered by an increase in asset market volatility and a rise in risk aversion.”
Such a move would boost the yen and Swiss franc against the dollar.
Central banks are expected to move some of their reserves out of the U.S. dollar and into other currencies as they try to “diversify risk.”
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