Aaron Task
SAN FRANCISCO -- As major equity averages continued to strike up the bland today, our attention returns to the paramount issues of the dollar and inflation.
"Whether the euro never looks back, I'm not so sure," said Lisa Finstrom, senior currency analyst at Salomon Smith Barney. "But I do think there's a building sense we are now in a phase where we will see continued strengthening of the euro."
The euro could slowly rise toward 95 cents in the next three to six months, Finstrom forecast, but suggested its gains will be hampered by ongoing concerns about Europe's economy.
But John Mesrobian, an analyst at Constantinople Advisors in Williamsburg, Va., which advises clients on currencies, commodities and bonds, believes the dollar will fall more dramatically in the coming months, with harrowing consequences for equities.
In tandem with a long-held bearish view on stocks, Constantinople Advisors has long argued the dollar is going to weaken substantially and recommends investors buy the euro, gold and related shares on weakness. (Today, gold prices rose 0.7% while the Philadelphia Stock Exchange Gold & Silver Index gained 2.7%, again outperforming major equity averages.) The euro's rise above 90 cents today augurs a move to 95 cents and beyond faster than most observers expect because "everyone is betting one way" via derivatives contracts, Mesrobian said. When investors start to unwind and/or cover their bets on continued dollar strength, "the move could be fast and furious." If the U.S. dollar index falls below 114, it could presage a move to as low as 105, he forecast. The dollar index, a measure of the greenback's value vs. a basket of other major currencies, was quoted at 115.21 today, down 4.7% since July 5. "All these foreigners speculating in the U.S. markets [are] hot money" investors, he said. "When the asset class they're speculating in, equities, is dropping, the currency is dropping, too, and economic numbers [show] the recovery is not what Wall Street promised, do you think they're going to hang around?" Finstrom and Mesrobian may disagree on the dynamics of the dollar's fall. But they do agree the main factor contributing to the euro's strength is that economists continue to push out the time for and pace of the U.S. economy's recovery. (This week's heavy docket for economic data includes retail sales tomorrow, business inventories and industrial production/capacity utilization Wednesday, housing starts and consumer price index Thursday, and trade deficit and consumer sentiment data on Friday.) The euro's strength "hinges on conditions elsewhere being less attractive," Finstrom said, recalling the euro was weak in 1999, even though Europe's economy was much stronger than it is today. To date, the U.S. has remained much more attractive to global investors. Foreign capital inflows into the U.S. totaled $155 billion in the first quarter, putting 2001 on track to eclipse last year's record of $456.3 billion, according to the Treasury Department. But in conjunction with falling expectations for the U.S. economy, Finstrom believes a "relatively restrictive" European Central Bank could limit future capital outflows from Europe, further aiding the euro. To many observers, the ECB's reticence to ease this year while the Federal Reserve aggressively cut rates will eventually make euro-denominated assets relatively more attractive than dollar-based ones. But increased expectations the ECB will ease at its policy meeting later this month has been cited as a catalyst for the euro's recent strength. Thus creating a paradox about which Finstrom chuckled. The currency impact of an easing by the ECB this month or next (which Salomon Smith Barney believes is more likely) will "depend on the context of the data" and the market's psychology, she said. If investors believe an ECB rate cut will generate more inflation than growth, the euro will likely stumble and vice versa, Finstrom said. "You can't say a rate cut equals a weaker euro, [but] the ECB is going to be very careful about the value of the currency" when determining monetary policy. To some observers, the same cannot be said about the Fed.
Wrong-Way Greenspan
Adjusted for the consumer price index, the real fed funds rate
is currently less than 0.5% and is barely positive when adjusted for the 3.6% year-over-year rise in the Cleveland Fed's median CPI. In other words, holding dollars has little (or no) value when adjusted for inflation. With the Fed expected to ease again next week, an outright negative fed funds rate appears to be a fait accompli. When adjusted for core personal consumption expenditures (PCE), the real fed funds rate is currently 2%, notes Brian Wesbury, chief economist at Griffin Kubik Stephens & Thompson in Chicago. (Cynics say Fed chairman Alan Greenspan has cited the PCE deflator as his favorite inflation gauge because it shows lower inflation rates than more commonly used indicators such as the CPI.) Presuming the Fed eases again next week, the real fed funds rate will be below 2% by any measure of consumer inflation, Wesbury said. "At [that] level, growth will no longer be hampered by tight money." "I think the news can get ugly, and we'll see more deflationary signs, [but] we believe that Fed rate cuts and Bush tax cuts are enough to bring the economy back early next year and allow the U.S. to avoid a Japanese-style episode," he wrote today. "As the economy bounces back next year and inflation remains a no-show, the environment for wealth creation will be almost perfect." Despite near-term concerns, Wesbury believes the so-called New Era economic theory he has long championed will be "back on track" next year after being "derailed by bad policy" in 1999 and 2000. Having long argued that inflation is more of a threat than deflation and that
a falling dollar enhances its potential return, I find myself at odds with Wesbury. I also believe the Bush administration's policies on taxes and spending suggest more dollar weakness, despite their repeated declarations of adherence to the strong-dollar policy. Although I fear otherwise, I do hope the ultimate outcome of any additional dollar weakness is closer to Wesbury's "almost perfect" scenario rather than Mesrobian's decidedly (and self-described) bearish view.
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