May 25, 2005
THE OECD BEFRIENDS THE DOLLAR
The OECD became the dollar's new best friend yesterday when the Paris-based group issued a warning that the euro-based economy has stumbled and needs help regaining its footing. That's hardly news, but the OECD's Economic Outlook was compelled nonetheless to restate the obvious in yesterday's newly released edition with the advisory that "what is badly lacking is sustained momentum in the euro zone."
The OECD projects that the euro region economy will expand by a slim 1.2% this year vs. 3.6% for the United States. Even Japan's projected 1.5% real GDP growth for 2005 beats euroland's outlook according to the OECD.
More than just good economic results are at stake. If there's any hope of fending off the future fallout of the growing global economic imbalance (namely, America's consumption binge relative to Asia's penchant for saving and Europe's economic stagnation), it will come in part from progress on jolting the Continent's economy into a higher gear. Or so we're told. The "continuing divergences in domestic demand between Europe and some Asian countries on the
one hand, and the United States on the other, cannot be treated with benign neglect," the OECD asserts.
Fixing Europe is a thankless challenge, to be sure. The Continent has long been trying to promote stronger GDP growth, but with little success relative to the U.S., much less Asia ex-Japan. One only has to look at the latest reported GDP numbers for proof. France and Germany, which represent the lion's share of the euro-based economy, muddled along with real annualized GDP advances of 1.7% and 1.1%, respectively, in this year's first quarter. No one can argue the point that such growth rates pale next to the 3.6% GDP rise in the first quarter for the U.S. What's more, Europe's diminutive status is far from new. In 2004, the euro region's GDP posted a 1.8% rise, less than half of America's 4.4% ascent, according to OECD.
Once again, the debate turns on what will cure Europe's ailing economy? Reforming the labor market so that firings and hirings are easier is a perennial favorite prescription, albeit one that receives mostly lip service.
One of the OECD's recommendations in its latest report is notable in that it also calls for boosting euro GDP by way of a fresh dose of monetary stimulus, otherwise known as cutting interest rates. Or as the OECD writes: "monetary policy may have an immediate role to play by significantly cutting policy rates. In the current context of low underlying inflation and weak aggregate demand, the case for easing the monetary stance in the euro area looks indeed rather compelling."
Fast forward to the relative interest rates of the U.S. vs. Europe. The Fed funds rate is currently 3.0%, up from 1.0% in June 2004. The equivalent rate set by the European Central Bank is 2.0%, which has prevailed since mid-2003.
From mid-2001 through late last year, the euro's key rate (the so-called main refinancing operations rate) has exceeded Fed funds. That premium in the euro rate has contributed to the currency's strength against the dollar. Indeed, the euro climbed sharply from mid-2001 through the end of 2004 against the greenback, advancing more than 50% over that span.
In 2005, however, the euro weakened against the buck, slipping about 7% year to date. The flip side of that is the rally in the dollar this year (the U.S. Dollar Index is up by roughly 6% so far in 2005). It's no coincidence that the renaissance in the dollar comes in the wake of multiple hikes in the Fed funds rate.
To the extent that rising interest rates lend aid and support to the formerly beleaguered buck, forex traders are betting that more of the same is on tap at the next Federal Open Market Committee meeting, which convenes June 30. On that date, another 25-basis-point rate hike is expected. Or so one could predict based on the fact that the inflation-adjusted Fed funds rate (Fed funds at 3.0% less the 3.5% annual rise in the consumer price index through April) remains negative at around –50 basis points. By this rudimentary measure of real Fed funds, a neutral inflation-adjusted rate (i.e., 0% real) was last seen stalking the monetary landscape in 2002. If the Fed is still intent on returning monetary policy to something akin to neutrality, it follows that another rate hike is in the offing.
The president of the Federal Reserve Bank of Atlanta suggested as much today. "My personal view is that we’ve not yet reached a neutral policy stance," Jack Guynn opined today in a speech to a homebuilders association, a group more sensitive than most to the prospect of interest rate hikes. "I have strongly supported the Fed’s actions to gradually remove our policy accommodation," continued Guynn, who doesn't have a vote in the FOMC's interest-rate setting decisions. "I believe our strategy to act before the appearance of widespread price increases is sound and necessary to keep inflation and inflation expectations firmly in check."
Where, then, does continued monetary tightening in the U.S. leave the euro? In a tight spot, and all the more so if the ECB takes OECD's advice and cuts rates. In that case, the euro's key rate would be falling while the dollar's key rate is rising. It doesn't take the smartest trader in the forex community to translate that into a tactical buy signal for the buck.
Then again, with ECB's key rate already at a relatively low level, future cuts are hardly assured. More likely, say some analysts, is that ECB rate hikes will be delayed. Reuters yesterday quoted euro zone monetary sources as saying that an ECB rate rise won't come until 2006. But keeping euro rates steady amounts to a defacto rate cut in relative terms if the Fed continues to tighten. As such, if it walks like a duck, and quacks like a duck, will forex trader cry fowl?
On the American side at least, tightening remains the trend du jour. The M2 money supply's seasonally adjusted annual rate of change, for instance, has been slipping of late, according to latest Fed data. For the 12 months through April 2005, M2 advanced by 4.1%, but rose by just 3.2% for the six months through April, and by only 1.7% for the three months through April. A trend with legs?
Maybe it's time to dust off the ancient art once popular in the early 1980s of watching the latest weekly monetary reports from the Fed, scheduled for release each Thursday at 4:30 p.m., Washington time.
In the meantime, the dollar seems to have secured some breathing room, temporary though it may be. Still, that's no small feat for a currency that otherwise looked set for extended tumbling based on the jump in America's trade and fiscal deficits in recent years, not to mention the so-far moderate rise in inflation by way of the consumer price index.
But if raising interest rates is bringing support to the buck, traders with more than a 20-minute investment horizon should be asking where we go from here. Can the Fed keep tightening? It can if the economic news on balance stays strong on a relative and absolute basis. On that score, another data point that gives the dollar bulls hope is this morning's durable goods orders, which rose 1.9% in April, the biggest monthly increase since November as well as a sharp turnaround from March's 2.3% decline.
Of course, just when you thought all the stars were aligning on one side of the economic aisle, along comes a new glitch. Today's installment was nothing new in the grand scheme of trends; rather, it's a reminder of an old gremlin that goes by the name of oil. The price of a barrel of crude jumped today above $50 for the first time since May 12. The trigger: U.S. oil inventories, the Energy Department reported today, unexpectedly dropped for the week ended May 20. That's the first drop in inventories in five weeks. Coming just before the unofficial launch of the driving season (Memorial Day weekend), the news was an easy excuse for buying.
The broader point, lest any one forget, is that oil imports, on which the U.S. increasingly relies, puts downward pressure on the dollar. Maybe that's why the U.S. Dollar Index slipped a bit today despite the seemingly bullish recommendation from the OECD on lowering euro rates.
Soaking it all in, investors may want to decide which scenario is more likely to prevail over time: an interest-rate premium in the dollar relative to the euro, or rising oil imports.
Ergo, the conflict between paper assets and tangible commodities remains alive and well.
Posted by jp at May 25, 2005 9:11 PM
With the sudden confession that the EU might just be done in France -- and therefore generally -- I wonder about the effect on the euro.
Posted by: Rob McMillin at May 26, 2005 8:50 PM