Wednesday May 23rd 2001, 12:24 PM
Preference for U.S. Assets Fuels Dollar's Ongoing Strength vs. Euro
By Allen Sykora
Overseas investors have preferred U.S. assets to those in Europe lately. And that is the main reason why the U.S.
dollar has been surging against the euro and other major European currencies, foreign-exchange market watchers
say.
A secondary factor has been greater investor confidence in the Federal Reserve's ability to manage an economy than
that of the European Central Bank (ECB), analysts said. The Fed has cut U.S. interest rates several times for a
total of 250 basis points so far this year, while the ECB has been skittish and trimmed rates once for 25 basis
points.
This trend toward dollar strength may well continue until overseas investors purchase enough U.S. securities to be
"happy with the balance," or else U.S. inflation figures start to jar the market's confidence in the Fed, sources
said.
The euro today fell to a low of 85.66 cents against the dollar, its weakest level since late November.
"The main thing is an underlying appetite for U.S. securities," said Sean Callow, currency strategist for
IDEAglobal. "The Fed has been aggressive enough in its action to keep underlying sentiment fairly upbeat in not
only U.S. stocks, but corporate bonds.
"It's not a case of selling euros and buying dollars because of daily events or intraday changes in the economic
outlook. It's more of a longer-term investment in the U.S. by European portfolio managers.
"European fund managers have had to make a decision: 'Do we turn our backs on the U.S. because the economy right
now has been poor. Or are we going to make a vote that holding U.S. bonds and equities over a longer period is
still a good investment decision.' They've been voting with their checkbook on that (latter option)."
Kevin Harris, international economist with MCM, pointed out that the Dow industrials are up a little more than 3
percent for the year. Meanwhile, he pointed out, London's FT-SE 100 index is down around 5 percent, the French
CAC-40 is down around a half percent, and the German DAX is down 3.2 percent. Of the major European markets, only
the Spanish IBEX-35 is higher for the year.
"If you were looking for capital appreciation from a stock portfolio, you would want to be in the United States
and not Europe," said Harris. "Stocks have become far more important to currency trade over the last decade than
would be reflected in the textbooks that still say it's the overnight rate that you trade."
Market watchers also pointed out that U.S. corporate bonds are also drawing considerable interest from overseas
investors. Further, the aggressive rate cuts by the Fed has created an environment in which many companies are
issuing more bonds than usual, Callow added.
"Corporate bonds have been a big story this year," he said. "Foreigners are buying a lot of that. By easing
interest rates so aggressively, the Fed has provided the ideal opportunity for U.S. corporates to issue new debt."
Said Harris: "Treasuries, at the medium to long end of the curve, still yield a premium to Europe. And agencies
and corporates, which are the preferred investment vehicles for an awful lot of Europeans, trade at a premium to
Treasuries. So there is a substantial premium in (U.S.) agencies and corporates to European debt."
Callow pointed out that there has also been an interest among European companies to take over firms in the United
States, also contributing to the dollar's strength.
"For instance, if telephone companies in Europe are looking to expand their global reach, the best way to do
that--they seem to think--is snap up some of the smaller U.S. companies. We've seen a steady increase in those."
Europe's economic performance is driving much of the interest in U.S. securities, related Harris. He pointed out
that European economies are not necessarily performing more poorly than that of the United States. However, the
European economy has not lived up to lofty expectations.
"The anticipation was that this would be the year of Europe," he said. "You could read about that in December and
January in lots of places--the European press, the U.S. press, the IMF (International Monetary Fund reports). They
all expected that Europe would have a solid year and that the U.S. would not.
"The U.S. is not having a solid year, but Europe is deteriorating every time they release data. We had new GDP
(gross domestic product) data out of Germany and France overnight, and they were disappointments."
Germany's economy grew 0.4% in the first quarter and 1.6% year on year, which fell short of analysts' expectations
for 0.5% and 2.0% growth, respectively. France's economy grew 0.5% in the quarter and 2.7% year on year, which
fell short of expectations for 0.7% and 3.1% growth.
"European economic performance simply hasn't supported any optimism by European stocks," said Harris.
And that brings up the issue of central banks.
"The secondary matter (in the euro's weakness) is confidence in the ECB," said Harris. "The Fed is decisive,
whether you like what they're doing or not. The ECB seems really trapped. The whole world recognizes the need for
the ECB to ease, and the ECB keeps getting worse and worse inflation data and saying, 'How can we do that?' They
seem very tentative."
ECB decision-makers trimmed rates by 25 basis points two weeks ago but did not act at their meeting today. By
contrast, the Fed has cut rates several times for a total of 250 basis points since the beginning of the year.
"You have a relatively untested central bank (the ECB is only a couple of years old) in charge of an economy that
is doing worse and facing a fairly rapid rise in inflation while they're watching the economy erode. They're
really stuck. The Fed has a much longer history and doesn't have to worry as much about its reputation, so it's
gone ahead and taken care of the growth problem despite rising inflation."
Said Callow of the ECB: "Their credibility, which wasn't that great to start with, has taken another turn for the
worse."
At some point, Harris noted, dollar gains become a "self-fulfilling cycle."
"You invest in currencies for two reasons," he explained. "One is to get the return on the (securities)
instrument, and the other is to get the return on the currency. A higher return on investments in the U.S. means
you are going to get a return on the dollar as more cash flows into the United States and boosts the dollar.
That's what's happened.
"It becomes a self-fulfilling cycle. As the dollar goes up, investment returns improve for European investors, so
the dollar goes up some more."
Harris looks for the dollar to remain strong until "everybody gets long in the dollar" or European economic
performance "stops deteriorating."
"As soon as enough investors have satisfied themselves, and shifted their portfolio to the point where they're
happy with the balance, the flow through the dollar will slow. It's like blowing on feathers. As soon as you stop
blowing, they begin to settle.
"You don't need people to rush into European assets to bring the dollar back down. You just need to stop the flow
through dollars and into U.S. assets."
While the dollar's upward trend against the euro has been strong, Callow offered the view that one potential
threat would be if the market should lose confidence in the Fed's ability to revive growth while keeping inflation
in check.
"There has been an uptick in inflation in recent months--the trend in wages and headline and core inflation. They
(Fed officials) tend to talk that down. In the last FOMC statement, they explicitly claimed that inflation was
essentially under control and no barrier to them, after dropping that reference in the previous FOMC statement.
"I think that (potential inflation) is the danger. For now, they (investors) are giving the Fed the benefit of the
doubt--inflation, while rising, will not get out of control so that Fed cuts won't exacerbate inflation, so that
growth can pick up. But if we get a couple of nasty CPI (Consumer Price Index) readings over the next couple of
months, then their faith would be shaken." |
