It’s been a wild month for the US dollar, as the currency plunged to a record low against the euro on March 16, rebounded to multi-week highs, and plummeted yet again this week. The moves suggest that, in the near-term, the EUR/USD pair could be returning to range trading, just like it did from November 2007 – February 2008. In the long-term, however, there are a few reasons why we don’t think the US dollar decline is over.
[B]1. The Federal Reserve Is Not Done Cutting Interest Rates[/B]
There was much fanfare following the Federal Reserve’s 75bp cut to the fed funds rate on March 18, as the markets had speculated that the central bank would implement a 100bp reduction. Moreover, two dissenting votes by Richard Fisher and Charles Plosser in favor of less aggressive monetary policy action suggested that the FOMC would start to shift away from the deteriorating economy and jittery financial markets in order to focus on inflation pressures from rocketing energy and good costs. However, it didn’t take long before the markets woke up and realized the reality of the situation: the Fed is going to cut rates further.
The economic picture looks quite dreary as well. This week alone we found out that S&P/Case-Schiller home price index plunged 10.7 percent in January from a year earlier to the lowest reading in nearly three years. Meanwhile, the Conference Board’s measure of consumer confidence tumbled to a fresh five-year low, boding ill for the next round of retail sales and general services sector reports. Businesses don’t appear to be faring well either, as durable goods orders slipped 1.7 percent and reflected a drop in spending plans in the next six months.
Clearly, the Federal Reserve has every reason in the world to continue cutting rates. True, they will likely cite some concerns about volatile energy and good prices. However, with core and headline CPI growth actually showing some slowing in February, the central bank will have some extra leeway to make monetary policy more accommodative. Furthermore, Chairman Bernanke and his fellow FOMC members have made it relatively clear that stability in the financial markets and the alleviation of the credit crunch remain their primary concern.
[B]2. US Dollar Speculative Positioning Has Not Hit Extreme Levels Yet[/B]
According to the most recent COT report, speculative positioning suggests that the US dollar has much further to fall before hitting extreme levels. The COT Index is the percentile of the difference between net speculative positioning and net commercial positioning measured over the last 52 weeks. A reading close to 0 suggests that a bottom is forming and a reading close to 100 suggests that a top is forming. As of last Tuesday, the 52 week COT index for the US dollar was at 69, indicating that plenty more selling is possible and in the longer-term, the trend is undeniably bearish – though does not rule out further correction in the coming weeks of trading.
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3. The Middle East May Still Be Considering Dropping Their Dollar Pegs[/B]
With the greenback trading near record lows, countries like Qatar and the United Arab Emirates are grappling with rapidly growing import price inflation and accelerated expansion as oil revenues rocket higher. In fact, during the third quarter of 2007, the Qatar Central Bank reported that inflation hit 13.7 percent (Qatar’s fiscal year ends on March 31). Meanwhile, the US Federal Reserve has reduced the federal funds rate by 300bps since September 2007 and the markets continue to price in additional cuts. Clearly, the synergies between the US and Persian Gulf countries have lessened quite a bit, making US monetary policy and more importantly, the US dollar, an uncomfortable fit for many Gulf Cooperation Council members, which includes Saudi Arabia, Bahrain, Kuwait, Oman, Qatar and the UAE. As a result, it is not surprising to hear that moving away from a dollar peg has been discussed by many of the GCC countries, but what are their options and how will it affect the US dollar?
[B]Pegging to a Basket of Currencies[/B] – Persian Gulf countries like the UAE, Qatar, and Saudi Arabia have a few choices when it comes to shifting their respective currencies from the dollar peg, but they will likely want to go with a method that has been tried and tested by one of the other GCC member countries: Kuwait. In May, Kuwait shifted their currency, the dinar, from a dollar peg to a basket of currencies. While the exact weighting has not been disclosed, the basket likely remains heavily weighted in the greenback, with the remaining portions in the currencies of some of their major trading partners, including Europe, the UK, and Japan. Since the shift, the Kuwaiti dinar has appreciated over 9 percent, indicating that a move to a currency basket is a very feasible option. In the short-term, the announcement of a shift to a currency basket by any of the other GCC members would be detrimental to the greenback, as it would suggest that the country would start to diversify central bank reserves away from the dollar and into assets denominated in the currencies of the basket. There is significant capital at stake, as Saudi Arabia’s foreign currency reserves rose 26 percent in September from last year to $259 billion, while the UAE’s reserves surged a whopping 65 percent in June from a year earlier to $43 billion. Furthermore, the risks of a sharp knee-jerk sell-off in the greenback would be exacerbated if a group of GCC members announced that they would all de-peg from the dollar, given the increased reserve diversification prospects.
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A One-Off Revaluation[/B] – Another option that some of the GCC members may consider is a one-off revaluation, which would maintain the dollar peg, but at a level that reflects an appreciation of the local currency. This is similar to what China did with the yuan in July 2005, when the currency was allowed to appreciate 2.1 percent within a single day. The primary reaction of the greenback was seen as a 2.7 percent drop against the Japanese yen, but the sell-off of the dollar also followed through to a lesser degree of approximately 1 percent against the Euro and British Pound. However, the price action did not carry over into the long term, as the prevailing trends of the pairs eventually took over within a few days. If one or more GCC members chose to implement a one-off revaluation, we would likely see similar results where the US dollar would drop against the majors, though the sharpest moves would likely be against the Euro and British Pound. Nevertheless, with central bank foreign exchange reserves likely to go untouched for the time being, the sentiment may wane rather quickly.