2008: Time to Buy the Dollar?

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.