RealMoney Silver - Dollar's Downtrend Appears to Be Ending

Dollar's Downtrend Appears to Be Ending
By Marc Chandler
RealMoney.com Contributor
5/16/2008 11:50 AM EDT

In my work, I find that the U.S. dollar moves in a large cycle against the euro, and before the euro it moved in a large cycle against the deutsche mark, relative to short-term interest rate differentials. Given the recent shifts in interest rate expectations and the somewhat firmer dollar, it is timely to review the dollar's super-cycle.

Recall that we are looking at two variables: the dollar's value and the direction of short-term interest rate differentials. With two variables, there are four possibilities. There are times when there is a weak dollar while interest rate differentials move against the U.S., as has been the case in recent quarters. The dollar may remain weak as interest rate differentials begin moving its favor. The dollar could strengthen as interest rate differentials continue to move in its favor, and later the dollar could strengthen when interest rate differentials begin moving against the U.S.

Since the late 1970s, the dollar appears to be moving consistently and sequentially through the four different phases. I am not pretending to offer some kind of holy grail. The limitations of this conceptualization are stark. It says nothing about the duration -- how long the dollar spends in any one phase. It also says nothing about magnitude -- how much the dollar appreciates or depreciates in any phase.

Nevertheless, the dollar's location in its super-cycle helps identify the underlying trend and may be more useful for long-term traders than for short-term speculators. In particular, recent developments lead us to believe that the dollar may be moving from what we have labeled phase 4, where short-term interest rate differentials are moving against the U.S. and the dollar is falling, to phase 1, where short-term differentials begin moving in the U.S.' favor but the dollar remains soft against the euro.

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As a proxy for short-term interest rates differentials, we use Euribor and Eurodollar futures contracts. The spread for the June futures contract peaked two months ago, on March 17, at a little above 227 basis points. It fell below 190 basis points last month and recovered to about 215 basis points now. The September spread peaked more recently, April 11, near 208 basis points, fell to about 175 basis points near the end of last month and is now trading near 197 basis points. The difference between the Dec Euribor futures and the Dec Eurodollar futures contract peaked on March 31, just above 182 basis points, and dipped below 150 basis points before recovering toward the mid-160s, where it is currently trading.

Admittedly, the interbank market remains under stress, but the two-year government sector shows us the same general development of interest rate differentials no longer moving against the U.S. and actually moving in its favor. Over the past month, the U.S. two-year yield has risen about 56 basis points, while a bond of similar duration in Germany has increased 44 basis points. To be sure, these are modest moves, but what is more important in our assessment is direction.

The economists' equivalent of Occam's razor, the philosophical principle that the simple solution is preferable, is that cyclical explanations ought to be given precedence over structural explanations, and only when the former prove unsatisfactory should we rely upon the latter. I have consistently maintained that the dollar's decline is largely a cyclical phenomenon, largely a function of growth differentials mediated by interest rate differentials and divergence in monetary policy between the Federal Reserve on one hand and the European Central Bank on the other.

The structural reasons other observers cite, such as diversification of reserves or the loss of the dollar's status as the numeraire in the world economy, we find lacking much evidence. The most authoritative data, which come from the International Monetary Fund, show that central banks hold more U.S. dollars than ever before.

The U.S. still runs a large trade deficit, of course, even if it has fallen in recent quarters. Nevertheless, we have found that over half the trade deficit can be accounted for by the movement of goods within the same companies. These intra-firm movements of goods, as trade has been in effect in-sourced, often do not require countervailing capital flows but are rather book entries in corporate accounts.

In addition, while the U.S. is the world's largest exporter, its companies rely on local affiliate sales rather than exports as the chief method of servicing foreign demand. Majority-owned affiliates of U.S. multinational companies will sell something on the magnitude of four times the amount the U.S. will export this year.

The U.S. dollar bottomed against half of the non-U.S. G7 currencies, sterling and the Canadian dollar last November. The dollar's location in its super-cycle does not preclude a marginal new low against the euro. It does support my view, however, that the dollar's multiyear downtrend is nearing an end. The shifting of interest rate differentials, which investors should continue to monitor, is another piece of the jigsaw puzzle falling into place for a broadening of the dollar's base in the period ahead.