Reaction to Fed cuts shows fundamentals are all wrong
for the US dollar
16 May 2001
So the Federal Reserve decided to cut interest rates by another 50 basis points. This is what most analysts had expected, but had feared would not happen.
There are very good reasons to think that the Fed may ease up on the easing. First of all, the US economy has proven to be stronger than earlier expected, even though first quarter performance -- at 2 percent -- was below trend . In addition, inflation indicators in the US show that it is actually reviving even as the economy slows -- consumer prices rose at a 4 percent annual rate between January and March. In other words, the Fed is actually caught between a rock and a hard place -- between promoting growth and containing inflation. That the Fed continues to move decisively to cut interest rates shows that its primary concern has shifted from inflation to growth.
The reaction of financial markets to the series of interest rate cuts is perhaps instructive. Even as the Fed cut interest rates by 250 basis points over the first four and a half months of this year, US 10-year Treasury bonds have stayed at yields of around 5 percent, actually hitting 5.49 percent yesterday, a level last seen in early December last year. US stocks have fallen in spite of the steepening yield curve, which is usually considered good for stocks, but short-term earnings concerns and excessive valuations may be the drivers there. As for the foreign exchange markets, the US dollar has risen against both the yen and the euro.
There is something contradictory in these responses. Rising long-term yields imply rising inflation. A deteriorating stock market outlook depresses investment returns. Now, if you accept the oft-cited argument that the rise of the US dollar in the second half of the 1990s was the result of low inflation and a rising stock market, the current situation of rising inflation and a deteriorating stock market should lead to a weakening currency. Instead, the US dollar has strengthened.
Of course, the strength of the US dollar in the second half of the 1990s has also been attributed to its stronger economic growth and its safe-haven status. Both conditions need to be re-examined now. US economic growth is expected to slow down -- rising inflation notwithstanding -- and is expected to come below European growth rates in 2001. And the perceived safe-haven status may be illusory. The US financial system may still be subjected to shocks. Not everyone believes that the stock market excesses have been eliminated. Market valuations remain near historical highs by some measures (refer to 4 May 2001 article). And the level of total debt remains persistently high at over US$18 trillion, or about 1.8 times GDP.
Over and above these considerations is the US current account deficit. This has been growing through the 1990s even as the US dollar rose in apparent disregard to what is conventionally considered one of the most important factors in currency movements. From 1995 to 2000, the deficit rose by almost four times. The 2000 deficit amounted to 4.4 percent of GDP, the largest among major advanced economies. And yet over this period, the US dollar, measured against a broad index of currencies, rose almost 30 percent.
With the US economy slowing, the International Monetary Fund has forecasted a deficit of 4.3 percent of GDP in 2001. In the first two months of 2001, the deficit has averaged about US$30 billion a month, or roughly the same rate as in 2000. So the deficit appears to be stabilising. But it is still huge by any measure. So far, the deficit has been financed by foreign investment in US-dollar-denominated assets and debt instruments. But if US inflation rises -- as the latest indicators suggest -- would foreigners continue to be williing to hold assets denominated in a currency that is losing purchasing power?
The almost-blind faith in the strength of the US currency can be seen in the US dollar/Sing dollar exchange rate. Being linked to some rather weak Asian currencies like the Indonesian rupiah, many analysts have suggested that the Singapore dollar should weaken against the US dollar. And indeed it has. Of late, this weakness has been exacerbated by recent merger and acquisition activity -- principally, the SingTel-Optus and DBS-Dao Heng deals. But in direct contrast to the US economy, the Singapore economy enjoys a current account surplus which, at 23.6 percent of GDP in 2000, is among the highest in the world. And just yesterday, the Monetary Authority of Singapore (MAS) reiterated its commitment to a stronger Singapore dollar.
Yet, Singapore-dollar bears -- or possibly US-dollar bulls -- are still convinced that the US curreency will rise against the Singapore dollar. On the same day that the MAS reiterated its stand, JP Morgan Chase and Hypovereinsbank predicted that the US dollar could rise to S$1.84 and S$1.90 respectively from about S$1.82 currently.
The noted Japanese commentator, Kenichi Ohmae, has his own explanation for the rise of the US dollar. In a recent column in the Los Angeles Times, he wrote: "The US government, industry and American consumers have long been the beneficiaries of Japan's instability. The loss of confidence in Japan's financial institutions and economic system drove Japanese institutional investors offshore. The capital flight out of Japan...mostly went to the US."
With Japan's new prime minister, Junichiro Koizumi, pledging to clean up Japan's financial mess, Ohmae believes that Japanese financial institutions would have no choice but to pull their money out of the US. He then went on to predict: "The US economy will experience a liquidity crunch, and both the Japanese and US economies will decline further. I predict that Wall Street investors will escape and take money out of their home country without hesitation into, for example, euro-denominated securities. This in turn will prompt the dollar to fall. And the necessary capital flight back to Japan will cause a major market correction, which will allow the US to finally realize just how much of its asset appreciation was due to support from the rest of the world."
Disclaimer: The commentaries posted here represent the opinions of the author at the time of posting and should not be taken as investment advice. Readers who wish to take any investment action based on information obtained from this site should seek appropriate advice from a qualified financial adviser.