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2008: Time to Buy the Dollar?

Marc Chandler

The first leg up in the US dollar is losing some momentum, and it would not be surprising to see the greenback pullback as the year winds down. This anticipated pullback will likely provide a new buying opportunity, based on technical and fundamental supports.

Consider the technical backdrop for the dollar. I monitor the 5-day and 20-day moving averages to help identify the near-term trend. In early December, the 5-day crossed above the 20-day moving average for the dollar against the euro, Swiss franc and yen. As is often the case, the dollar's move was initiated first against sterling and the bullish dollar signal was generated in mid-Nov.

In addition, the euro, yen and dollar index all appeared to carve out head-and-shoulders reversal patterns.

In the euro, the pattern projects a move toward $1.4100, just below the 50% retracement of the euro's rally since mid-August. The 61.8% retracement is found near $1.40.

The head-and-shoulders bottom in the dollar against the yen projects toward JPY115.00. The 50% retracement of the dollar's summer and fall decline against the yen comes in near JPY115.70, and the 61.8% retracement is seen near JPY117.70.

However, the first phase of the move may already be completed. The euro has fallen to almost $1.4300 from the peak of $1.4965 on Nov. 23. In recent days the euro's downside momentum has faded and it looks like a base is forming from which the euro could bounce back into the $1.4500-$1.4600 area before the new year. From there it may be worth trying to sell again.

Sterling has been hit the hardest. Under the weight of a slowing economy, expectations for this month's rate cut and anticipation of additional rate cuts in the first quarter of 2008, sterling has been sold from $2.1160 on Nov. 9 to a low just above $1.98 in recent days. It too appears to have run out of momentum and a near-term bounce seems likely. It could carry the pound back toward $1.9950-$2.00 before falling out of favor again.

The underlying fundamentals are unlikely to change much over the next couple of weeks. The economic data is light, as is participation.

Perhaps leaving aside the credit crunch is like asking Mrs. Lincoln how the play was, but the recent U.S. economic fundamentals are more constructive than some economists have suggested.

The U.S. consumer is not dead. Personal consumption rose 1.1% in November and the October increase was revised to 0.4% from 0.2%. Consider the monthly data, where personal consumption expenditures rose 1.3% in both the second and third quarters after growing 1.5% in the first quarter. Even if December consumptions are flat (which seems unlikely, the monthly figure has been positive since Sept 2006), the Q4 gain is 1.5%.

In addition, the slightly smaller trade deficit and the increased government spending is likely to offset the drag created by the slower inventory accumulation.

Meanwhile, nearly all inflation measures surprised to the upside -- import prices, producer prices, consumer prices and the PCE deflator (headline and core). The February Fed funds futures contract implies an 86% chance of a 25 basis point rate cut. The market is not convinced that the Fed will cut again at the March 18 FOMC meeting, but the market is completely discounting a move to a 3.75% target by the end of April (the third FOMC meeting of the year is April 30th).

It is difficult to attach much import to the far back month Fed funds futures contracts, which are so thinly traded, but the market appears to be leaning toward a 3.5% Fed funds rate by the middle of the third quarter.

The negative news for the US seems largely factored in, although it is an evolving situation, but the market, it seems to me, continues to not fully appreciate the risks abroad. Growth in Europe is slowing and the ECB cannot afford to cut rates in a preemptive fashion because its two monetary pillars -- money supply and inflation -- are still strong. The Federal Reserve began cutting US rates, in contrast, in the middle of the third quarter as the economy was growing at almost a 5% annualized clip.

The Bundesbank recently revised its forecast for German growth next year to below 2%. The Japan's official forecast is for it to expand by 2% next year. The chances that either the ECB or the BOJ are able to raise rates again appear to be dwindling with every new piece of economic news.

As I have argued here before, the risk is that the ECB is forced to cut rates toward the end of the first half of next year.

In some ways Japan is in a more difficult position. Even with the longest economic expansion in modern Japanese history, the central bank has been unable to normalize monetary policy, and the government has been unwilling to normalize fiscal policy.

The overnight interest rate target is 50 basis points, so there is not a great deal of scope for government or central bank policy to preempt or mitigate an economic downturn, which is looking increasingly likely, especially for the domestic economy (excluding exports).

Despite its imperfections and excesses, in the coming months, the attractiveness of the U.S. as a point of production and sourcing, and its assets (real and equity), may reemerge as the topic of cocktail conversations.

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