Two Options

Bernanke Diverging With King Means Dollar May Decline (Update1)

By Rich Miller

Aug. 20 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke and fellow central bankers gathering in Jackson Hole, Wyoming, are showing scant signs of reprising the coordinated stance they took fighting the worst financial crisis since the Great Depression as they deal with its aftermath.

The danger is that such a disjointed approach will lead to volatile financial markets, a damaging drop of the dollar and slower global growth, Mohamed El-Erian, chief executive officer of Newport Beach, California-based Pacific Investment Management Co., said in an interview.

“The question is not whether the dollar will weaken over time, but how it will weaken,” said El-Erian, a former deputy director of the International Monetary Fund whose firm runs the world’s largest bond fund. “The real risk is that you will get a disorderly decline.”

By the end of 2010, the euro will rise to about $1.60, its highest since April 2008, while Canada’s currency will appreciate to C$1.01 per U.S. dollar, its strongest since July 2008, as the U.S. is slow to tighten credit, said Sophia Drossos, co-head for global foreign-exchange strategy at Morgan Stanley in New York.

The euro traded at $1.4234 at 6:00 p.m. in New York yesterday, while the Canadian dollar was at C$1.0952 per U.S. dollar.

Gaining Traction

Bernanke, 55, and other policy makers, who meet on Aug. 20-22, are already staking out differing positions as they gain traction in their battle against a crisis that has cost financial companies worldwide about $1.6 trillion in writedowns and losses. The U.S. economy is forecast to grow by more than an annualized 2 percent in the second half of 2009 compared with an average contraction of more than 4 percent in the last two quarters of 2008, according to a Bloomberg survey of economists.

Bank of England Governor Mervyn King expanded an unprecedented bond-purchase program by 50 billion pounds ($82.7 billion) on Aug. 6 to 175 billion pounds, saying the recession was “deeper than previously thought.” Less than a week later, on Aug. 12, the Fed said it would slow its buying of $300 billion in Treasury securities and finish by the end of October as the economy levels off. On Aug. 5, Bank of Israel Governor Stanley Fischer ended government-bond purchases as the economy resumed growing in the second quarter after contracting during the previous six months.

“What you would hope to happen is much better coordination internationally,” El-Erian said. “What’s likely to happen, however, is that national interests are going to dominate.”

United Front

Such divergent approaches contrast with the united front central banks took in the wake of Lehman Brothers Holdings Inc.’s collapse last year, when the Fed, European Central Bank, Bank of England, Bank of Canada, Swiss National Bank and Sweden’s Riksbank all cut interest rates on Oct. 8. The Fed also set up a record 14 swap lines with foreign central banks to provide them with dollars to ease a global liquidity squeeze.

The banks were forced to cooperate by the severity of the global credit crunch, said Peter Hooper, chief economist for Deutsche Bank Securities in New York and a former Fed official.

As the crisis ebbs, the desire to act in concert is likely to fade, Hooper said. The IMF forecasts the global economy will expand 2.5 percent next year after shrinking 1.4 percent in 2009.

“The biggest risk of central banks going at their own pace is currency overshooting,” Jim O’Neill, head of global economic research at Goldman Sachs Group Inc., said in an interview from London.

Buy Currencies

Morgan Stanley’s Drossos recommends buying the currencies of countries that are likely to be among the first to raise interest rates while selling those of nations that have used quantitative-type easing to pump liquidity into their financial systems. She puts Australia and Norway in the first group and the U.K. and the U.S. in the latter.

Norway’s central bank will raise its benchmark interest rate from a record low of 1.25 percent in October as the economy recovers, Dominic Wilson, a New York-based senior global economist at Goldman Sachs, wrote in a research note to clients today. The firm recommended buying the krone versus the euro in one of its “top” trades.

In the U.S., the Fed has traditionally given little weight to the value of the dollar is setting monetary policy, Hooper said. President Barack Obama, in contrast, is counting on increased exports to propel the economy, according to National Economic Council Director Lawrence Summers.

‘Sustainable Expansion’

Stronger exports are a “foundation for sustainable expansion,” Summers said in a March 13 speech at the Brookings Institution in Washington. Such shipments made up 12.7 percent of U.S. gross domestic product last year.

Summers, 54, who is considered by economists as a candidate to replace Bernanke when the Fed chairman’s current term ends in January, raised the possibility that major central banks should pay more attention to exchange rates at the Jackson Hole symposium six years ago.

Then president of Harvard University in Cambridge, Massachusetts, Summers described his remarks as “provocative” and also asked whether monetary-policy makers should give greater weight to financial stability. He declined to elaborate, NEC spokesman Matthew Vogel said.

Even at current exchange rates, the U.S. current-account deficit in trade of goods and services will widen to a record of more than $850 billion in 2012 from about $400 billion this year, said John Williamson, senior fellow at the Washington- based Peterson Institute for International Economics.

‘Orderly Fall’

An orderly fall of the dollar would be good for the world economy as it helps the U.S. continue to expand while consumers retrench, El-Erian said, declining to be more specific about currency levels. Such a drop would also help other countries including China wean themselves off their dependence on exports, promoting growth worldwide in the process, he said.

While the U.S. economy is picking up, the recovery is being driven by inventory rebuilding and Obama’s record $787 billion fiscal stimulus, Olivier Blanchard, chief IMF economist, suggested in a paper released by the Washington-based lender on Aug. 18. Neither will last, he added.

That means exports “must increase” for a sustained U.S. recovery to take place, he said. To help achieve that, “some coordination across countries is likely to be as crucial during the next few years as it was during the most intense part of the crisis.”

Derail Recovery

Without that coordination, there’s a danger of a disorderly dollar fall that would destabilize financial markets and could derail the recovery, he said.

The dollar has lost 12 percent since March 5 against an index comprising the euro, yen and four other major currencies.

While 54 strategists surveyed by Bloomberg News forecast that the dollar will end the year little changed, on average, from current levels against the pound and euro, volatility is already hurting some U.S. companies.

Avon Products Inc., the world’s largest door-to-door cosmetics seller, partly blamed currency fluctuations for a drop in second quarter net income to $82.9 million, or 19 cents a share, from $235.6 million, or 55 cents, a year earlier.

“Foreign exchange continued to significantly pressure profits,” Andrea Jung, CEO of the New York-based company, said in a July 30 statement.

Major Risk

The Bank of Canada is already wrestling with what to do about gyrations in the currency market. Governor Mark Carney said July 23 that the stronger Canadian dollar was a major risk to economic growth. Finance Minister Jim Flaherty followed that up on August 4 by signaling that steps could be taken to dampen volatility in the currency.

The bank may extend its commitment to keep interest rates at a record low 0.25 percent beyond the middle of 2010 if a strong currency threatens to prolong the recession, said Derek Holt, economist at Scotia Capital in Toronto. The Canadian dollar has risen nearly 16 percent against its U.S. counterpart since March 9.

Fischer at the Bank of Israel is also grappling with unwinding an expansionary monetary policy while trying to contain the rise of the nation’s currency, the shekel, which has gained about 3 percent against the dollar since June 30.

With Barclays Capital forecasting on Aug. 5 that the Israeli economy will grow by 2.9 percent in 2010 after a 0.9 percent contraction this year, the 65-year-old central-bank governor is beginning to rein in his expansionary policies.

Raise Rates

Israel will be the first central bank to raise interest rates, perhaps moving as early as next month, said Koon Chow, an emerging-markets strategist at Barclays in London.

That might lead to a steeper-than-desired rise of the shekel, he said. That is why former IMF deputy managing director Fischer, who is giving the luncheon speech at Jackson Hole on Aug. 21, has established a policy for the bank to purchase foreign currencies in the event of “unusual movements” in the shekel.

Monetary-policy makers worldwide may stay in sync if forecasts of an economic recovery prove stillborn and central banks hold off on tightening credit. Economists surveyed by Bloomberg put one-in-five odds on the possibility the U.S. will relapse into a so-called double-dip recession in the next 12 months.

David Kotok, chairman of Vineland, New Jersey-based Cumberland Advisors Inc., sees a risk of increased instability in foreign-exchange markets once policy makers start to sop up the money they have pumped into the global financial system.

“If central bankers act without coordination, they may find their currencies hammered or upwardly valued as markets react strongly or viciously” to interest-rate differentials, said Kotok, whose firm manages more than $1.2 billion. “Foreign-currency volatility will quickly cause adjustment in interest rates in the government-bond markets of the world.”

From my perspective, there are some real dangers with the game the Fed is playing. The implication of the "orderly decline option" (the rise in the Euro and Canadian dollar by 10% or so), is that the US dollar index could drop as low as 70 or 71. The impact would likely boost crude prices beyond $80 (and the next fibonacci level of $78) and gold. Crude prices in particular are a concern as this has the potential to derail any economic recovery that "may be" happening in the US and other countries. Crude prices translating into higher gasoline and diesel costs would act as a catalyst to boost transportation costs and food prices. This is the last thing the beat up American consumer needs. A significant increase in crude prices combined with the higher savings rate (around 7% now) will reduce discretionary spending substantially and we end up in an L shaped recession.
This is contingent upon a recovery actually occuring. In my view, there is a significant possiblity of a pull back in crude prices to the $40 - $50 range because of very high inventories and sluggish demand.
The second option, a "disorderly decline", is that at some point in the near future, there is a bond auction failure. Which creditors are going to continue to lend 10 year money to the US at 3.5% the way the Feds are racking up unimaginable amounts of debt? This scenario leads to much higher crude oil prices and higher interest rates. That would really sink any recovery that may rise from the ashes of this recession.
For more on this topic consider the post: