US Dollar Report · Observations indicate that the US dollar typically appreciates in value during recessions. However, this time around, the situation appears atypical and the general

US Dollar Report17th March 2008Anthony Grech,Research Analyst,IG Index

IG Index plc US Dollar Report 217th March 2008

Anthony Grech, Research Analyst, IG Index

ObjectiveThis report identifies the historic performance of the US dollar, unveils key trends during past recessions, and attempts to determine the direction of the dollar for 2008.

Dollar in decline: the trends of the greenback As the US dollar struggles in the face of recession, what do past trends tell us is to come?



IntroductionOver the past five years, the value of the US dollar has fallen by 18% against the British pound and plummeted by 26% and 20% against the euro and yen respectively (see Chart 1).

The sharp decline in the US federal funds interest rate towards the end of 2001 (a recessionary period characterised by the bursting of the dot-com bubble, accounting scandals and September 11 terrorist attacks) was one of the most important contributing factors that led to the depreciation of the US currency during the period covered in Chart 1 and Table 1.

The Federal Reserve intentionally eased interest rates in order to aid the recovery of the American economy. This reduction of interest rates between 2001 and 2004 widened the gap between US and foreign rates. Chart 2 shows that interest rates in the US fell by 550 basis points to 1% during this period, while the lowering of interest rates in the UK was less pronounced and fell by 250 basis points to 3.5% during roughly the same time span. As a result, deposits denominated in British pounds became more attractive because they paid a higher rate of interest than US deposits. The shift in demand from US to British denominated deposits therefore helped the British pound appreciate against the US dollar.

The weaker dollar, which resulted from lower interest rates, helped the US economy in the following ways:

It made domestic goods less expensive relative to foreign products, which in turn dampened demand for imports and boosted domestic production and exports. As a result, it helped to narrow the US trade balance - as seen in Chart 3.

Lower interest rates decreased the cost of borrowing, allowing easier access to cheap credit. This stimulated } domestic consumption which led to an increase in business expansion.

In the following section, movements of the US dollar index from January 1971 to February 2008 are observed, in an attempt to identify possible trends.

Chart 1 – 5YR USD Performance To 15 Feb 08

Table 1 – 5YR USD Performance

Chart 2 – 10YR UK & US Interest Rates & USD/GBP



Chart 3 – 10YR US Trade Balance (Billions US$)

USDX Index breaches support levelThe chart below shows the US dollar index (USDX), a trade weighted measure of the US dollar against a basket of major currencies, from January 1971 to 15 February 2008 [1].

Chart 4 shows the USDX breaching the critical 80-point support barrier in September 2007, a level which supported the downturns of 2005, 1995, 1992 and 1991.

The index fell to 74.859 on 26 November 2007, a record low at the time of writing since the course of the dollar’s free floating period, and fluctuated between this level and 77.7 points. From a technical analysis perspective, the breaching of the critical 80-point support barrier suggests that the US dollar may be susceptible to further weakening.

Chart 4 – USDX Index

Dollar direction during US recessionsThere is much discussion about the likelihood of the US entering recession this year, so what does this mean for the dollar?

Chart 5 and Table 2 plot the American dollar against the British pound from 1971 to 2008 and shows five US recessions (see shaded areas).

The graph clearly shows that the US dollar is typically supported during recessions (the recession in 1980 being the exception). A closer observation shows that the US dollar starts to gain support slightly before the US economy enters a recession in four of the five recessionary periods. This occurs because the market anticipates that the economy will officially enter into a recession and start to recover from that point onwards. As a result, the US dollar starts to attract attention because the market knows that interest rates will eventually increase in order to tame rising inflationary pressures.

Chart 5 – USD/GBP during recessions

[1] Figures before 1972 are not comparable because the exchange rate mechanism operated under a different regime which fixed the dollar at a rate established by the Bretton Woods Agreement. In 1972 the system was abolished and exchange rates were allowed to float freely.



Table 2 – USD/GBP during recessions

Expectations: recession vs stagflationFrom a technical analysis perspective, the USDX broke through a major support level indicating that there is the possibility of further dollar weakness. On the other hand, there is evidence pointing to the fact that the US dollar is generally supported during a recession.

These observations appear conflicting, however, I believe that the situation may be better understood when market expectations are put into context. At this juncture, the market appears to be having a difficult time trying to figure out whether the US will be moving into a recession, which typically lasts around 10 months [2], or a period of stagflation, a situation last seen in the early 1970s.

Stagflation is a period of elevated levels of inflation, rising unemployment and weak economic growth. During this phase it is difficult to raise interest rates to counter inflation because such a manoeuvre would be more damaging to the economy. Therefore, if the US enters a period of stagflation, there is a good chance that the US dollar may continue falling as rates would have to be kept low in order to aid the economy’s recovery.

In my opinion, the reason why the USDX breached the 80 point barrier but has not fallen significantly below this level reflects that the market is indecisive about whether the US is entering a typical recession or a period of stagflation.

The chart and table below show the year-on-year Unemployment Rate, Consumer Price Index (CPI) including all items, and a CPI figure excluding food and energy.

The trend during the last six months shows the CPI, an inflationary indicator, and unemployment levels picking up against a background of weak economic growth, measured by the Gross Domestic Product (GDP). During the fourth quarter of 2007, GDP grew at a meagre 0.6% (annualised) as opposed to market expectations of an increase of 1.2% [3].

Chart 6 –SA Unemployment Rate & CPI (YoY)

Table 3 – SA Unemployment Rate & CPI (YoY)

[2] David A Rosenberg (4 February 2008), Merrill Lynch Economic Commentary, ‘Lower rates bump against credit contractions ‘

[3] Thomson Financial (30 January 2008)



FOMC MinutesOn 20 February, the Minutes of the Federal Open Market Committee (FOMC) for January 2008 were released. Ben Bernanke, Chairman of the Federal Reserve, stated that he was expecting GDP growth projections for 2008 to be revised lower between 1.3% - 2%, from previous estimates which ranged from 1.8% - 2.5%. The decrease was attributed to the intensification of the housing market slump, tighter credit conditions, the ongoing turmoil in financial markets and higher oil prices.

Mr Bernanke stated that the implementation of a fiscal stimulus package would boost domestic demand by the second half of 2008, with real GDP growth gaining momentum in 2009 through to 2010. In addition, he also mentioned that a gradual turnaround in the US housing market, combined with a lower interest rate environment and with an improvement in the unemployment rate, should help the US economy to recover. Access to credit, which has been in a tightening phase, was identified as another important factor affecting economic growth, with the main focus of the Minutes being growth rather than inflation.

OpinionObservations indicate that the US dollar typically appreciates in value during recessions. However, this time around, the situation appears atypical and the general rule of thumb may not apply, therefore, at least till the third or fourth quarter of this year. The following section explains why I believe that the US dollar may remain weak.

At this juncture, the Federal Reserve’s primary objective is to tackle the problem of economic growth. In order to achieve this, the Fed has lowered interest rates and more recently introduced fiscal rebates. Rates were slashed by 225 basis points to 3% in a series of cuts from August 2007 to January 2008. Federal fund implied probabilities compiled by Bloomberg on 27 February 2008 indicated that the market is expecting the Fed to slash interest rates by a further 100 basis points to 2% by the end of 2008 in order to continue stimulating the economy [4].

Once sufficient growth is achieved, the Fed’s priority will shift to its secondary concern, namely inflation. However, in my opinion, this plan may not be feasible because inflationary pressures, stemming from the significant rise in the value of oil, commodities and food, have already started to present themselves against a backdrop of weakening economic growth.

The Fed is now faced with a dilemma: keep interest rates low in order to help the economy recover from the damage of the sub-prime crisis and in the process maintain a weak dollar and risk spiralling inflation, or confront inflationary pressures with increased interest rates and face the prospect of an even greater downturn in the economy.

In my opinion this situation is delicate, almost a vicious circle, because although the Fed may prioritise growth, it simply cannot ignore inflationary pressures: a prolonged period of persistently high inflation may bring the economy back to square one - weaker growth. This was characteristic of the stagflationary period last seen at the beginning of 1970s.

I do not believe that this period conforms to the general 10 month recession which usually attracts US dollar support, owing to a combination of the following reasons:

A weak dollar, the interplay between geopolitical tensions and the strength of emerging market economies is supporting the higher price of oil and commodities, which is responsible for raising costs and elevating inflationary pressures (cost-push inflation)

Increasing demand for commodities from emerging market economies

The rise in the number of sub-prime mortgage holders defaulting on their loans is contributing to the increase in repossessions and the deterioration of the US property market. This phenomenon is working its way through the banking sector and the wider economy and is being reflected in an increase in the unemployment rate, which is one of the factors responsible for the weakening economic environment in the US. Hope of a recovery of this situation appears to dictate a need for lower interest rates.

The effect of the sub-prime crisis has not been as pronounced in the UK and Europe, meaning that the European Central Bank (ECB) and the Monetary Policy Council (MPC) can afford to be hawkish on inflation for the time being. This reinforces the notion of the US dollar remaining weak, especially against the British pound and euro.

In the medium to long term, however, if sufficient economic growth is achieved in the US, emphasis will have to be placed on combating inflationary pressures, and this suggests that there is the possibility of the dollar appreciating against the euro and British pound, especially if Europe and Britain start to feel a greater impact of the sub-prime crisis.

[4] Bloomberg (27 February 2008)



Analyst ForecastsSpot GBP / USD on 29 Feb 08: 1.99

Spot EUR / USD on 29 Feb 08: 1.52

DiscaimerNo representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. The research does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. IG Index is authorised and regulated by the Financial Services Authority (FSA No: 114059).

Documents

US Dollar Report · Observations indicate that the US dollar typically appreciates in value during recessions. However, this time around, the situation appears atypical and the general