US Dollar, Global Rates, & Our Fed
A: US Dollar is getting pounded today as the Bank of England does what it needs to do to stave off inflation concerns and keep economic growth at bay; it raised its overnight lending rate 1/4 point to 5.75% strengthening their currency over the US dollar. With our fed on hold for the foreseeable future, we don't have the catalyst to support our own dollars. Meanwhile, the European Central Bank left rates unchanged at 4% but will most likely hike rates before October. At home, energy & commodity prices are still high, inflation seems to be moderating (for how long I wonder) and the economy seems resilient to the still worsening national housing correction. In short, there is NO WAY the fed can afford to cut rates anytime soon and bond yields are clearly in a generally upwards trend.
Three reasons why the fed can NOT cut interest rates and rather could be argued in favor of a rate hike include:
1. Globally Rising Rates / Strong Global Economies - Rates are in an upwards trend across the globe as central banks attempt to balance growth & inflation at the same time. A very hard job to do. With very strong economies in Europe, Asia, and some other emerging markets (much stronger growth than we are seeing here in US), rates have risen to slow things down and help prevent inflation from getting worse. The job is still not done yet because the story is still being written. Right now, you are STILL seeing the after-effects of years of ultra cheap money and mega liquidity! While the engine to this freight train has been slowed, the speed of the train is yet to come down with it! No way the fed cuts rates while global central banks continue to hike theirs!
Keep close tabs on how this plays out because in the years to come we will eventually see the ultimate effects of rising rates and trimmed liquidity. For now, enjoy the good times and try to learn how long it takes for globally rising rates to have a slowdown effect on economies; which is the ultimate goal by the way. Why slow things down? Central banks know that by letting economies grow like wild fire and inflation to get out of control will have much more severe long term effects than if slowed down in a calculated manner.
2. Weak US Dollar Must Be Supported - Due to the Bank of England's rate hike to 5.75% we are seeing strength in the british pound versus the US dollar. It now takes over $2 US dollars to buy 1 British pound, a record high I believe. Here is a 1 year chart showing the downward trend of the US dollar's worth versus the pound:
The drag on the US dollar doesn't stop here as the Euro is also enjoying highs against the dollar making American assets very cheap for Europeans. An argument can be made that Manhattan real estate is being supported by foreign buyers taking advantage of currency trends; among other fundamentals.
As long as our fed stands on the sidelines with monetary policy, which they obviously are doing, the US dollar will gain little support from our policy makers and will continue a trend of erosion.
3. High Energy & Commodity Prices Could Be Inflationary - At a lag that is. With the price of oil hovering over $70/barrel and the US dollar weakening causing other commodities to rise (gold, silver, etc.) future inflation concerns are warranted. Rises in the price for corn, oats, wheat, milk, cocoa, orange juice, etc. just can't be ignored. No matter how you cut it, with commodity prices at such high levels one can only hope that this doesn't trickle down the economic system in the future leading to a general rise in prices paid for goods. For some, this has already happened.
Looking at the big picture, we have enjoyed ultra cheap money and tons of liquidity for many years leading up to today's global environment. Now that rates rose a bit, its narrow minded to think its over. In general I see a cyclical upwards trends in global rates the end of which is not in sight. It is very possible that rates continue their slow, upwards trend for years to come. Fact is, these are very confusing times and todays economy is vastly different than from past history. Questions I wish I could have answered include:
1. How will credit be effected by CDO mess?
2. What the longer term effects of high commodity/energy prices will be?
3. How high will rates have to go?
4. How low will US dollar fall before stimulative measures need to be taken?
5. What is the next unforeseen event?
6. What can possibly stop globalization?
7. Which global economy will be the first to unravel?
8. How will hedge funds react to changes in tax code?
9. Will capital gains tax be changed?
10. Will the fed's next move be a hike or cut?
Thoughts?
Posted by Marmotton
Thu Jul 5th, 2007 12:53 PM
Thanks again Noah for the thorough analysis. As you hinted cheap debt and commodity prices are putting inflationary pressure on the economy.
On the debt side, cheap money has contributed to an historical spike in privatization, particularly everything real-estate related (look at HLT on Tuesday). The consequences are starting to show, as the WSJ reported this AM: rising rents, tolls, etc. These increases will end up being passed on to customers as price increases from dry cleaning to every service that requires brick-and-mortar presence in metropolitan areas (local grocery stores, etc). Commodity price increases have also trickled down to food prices.
The availability of cheap debt will have to stop soon and raising interest rates is the only way to make it happen.
Therefore, the feds have to raise rates sooner than later if they do not want to see a huge spike in inflation and a drop in real-dollar-adjusted household income with a severe recession not far behind.
Posted by Noah
Thu Jul 5th, 2007 01:33 PM
Agreed! However, Im not sure what our fed will do. I think they want to see the tradable markets correct themselves without the need for further tightening of monetary policy.
CDO mess could very will raise rates on their own, especially if that problem is just beginning, which I think it is. I worry about how deep this will spread in the hedge fund world as time goes on.