Benign Bets on the 'Scary' Trade Deficit

Friday's report is unlikely to move the dollar, which is more focused on the Fed's next move.
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It used to be that many people were betting the dollar would come under severe pressure because of the soaring U.S. trade deficit. Those bets have turned out wrong time and again.

Little reaction is again expected from the December trade numbers slated for release Friday, unless they come out much worse than expected. The report is expected to show that the gap between U.S. exports and imports worsened only slightly to $64.8 billion in December from $64.2 billion in November, according to a

Reuters

survey.

An in-line result would be below the record $68.9 billion deficit posted in October, but it still amounts to roughly 6% of gross domestic production.

The improvement in December comes from an increase in consumption -- of non-U.S. made goods -- in the last month of 2005, according to Joseph Abate, economist at Lehman Brothers.

The trade gap, together with consumers' negative savings rate, means that America consumes products and services with money that comes from somewhere other than the fruit of labor and domestic production.

That funding comes from foreign purchasers, be they central banks or offshore hedge funds, of U.S. financial assets, be they stocks or U.S. Treasuries.

Based on the strong participation of indirect bidders, which include these foreign buyers, at Thursday's auction of $14 billion worth of 30-year Treasury bonds, the money is still coming in.

The

successful auction helped lift the price of the 30-year bond, which hadn't been issued since 2001, and bring down its yield on Thursday. Wednesday's auction of 10-year notes was also successful.

Strong foreign buying of U.S. assets, meanwhile, does nothing to help the trade imbalance correct itself via a weakening dollar, which is what should happen under "normal" circumstances. The weaker currency would make U.S. exports more attractive.

The dollar, which firmed against expectations throughout 2005, had begun to decline late last year but it has again been on the uptrend since mid-January.

The key reason is that, as in 2005, the market is again expecting that the

Federal Reserve

will continue to lift interest rates for a while longer. When short-term rates are poised to move higher, holding dollar-denominated assets is a safe way to keep money in the short term.

Attracting foreign capital flows also keeps the U.S. current account deficit, which measures not only trade in goods and services but also financial flows, well financed.

You Wash My Back...

Everybody, in fact, seems to be satisfied with the U.S. imbalances. The flows of capital from Asia find themselves in long-term Treasury bonds, helping keep yields low, as well as associated mortgage and refinancing rates.

U.S. consumers, able to borrow against the value of their homes, use the money to purchase mostly foreign-made goods, which fuels the trade imbalance and provides foreigners with more capital to invest in U.S. assets.

Low long-term rates also provide easy access to capital for businesses, as well as for the government.

Why would anyone want to change the situation?

Indeed, a correction in the current account deficit could have disastrous consequences. This might come from a steep drop in U.S. consumption, which would slow demand for foreign-made goods. This would also cut the ability and the incentive for foreigners to finance the deficit, and would likely result in a sharp upswing in interest rates.

Not surprisingly, a recent poll of 700 global investors by Lehman Brothers found that topping the list of global concerns about the global economy was a slowdown in the U.S. housing market, which itself has fueled strong U.S. consumption.

There might also be problems if the Fed, presumably concerned about such a slowdown, stops raising rates. This would leave the dollar vulnerable, also making it less attractive for foreigners to finance the current account deficit, and could also cause a spike in long-term rates.

Where does that leave new Fed Chairman Ben Bernanke, who has repeatedly signaled his belief that what was keeping long-term Treasury yields low was "a savings glut" from the rest of the world?

According to Ashraf Laidi, currency strategist at MG Financial, Bernanke will need to keep uncertainty about when the Fed eventually stops raising rates for as long as possible. This would keep the dollar supported while allowing the housing market to have a soft landing, without causing a consumer meltdown.

The currency market, as well as the stock and bond markets will likely hold off taking fresh positions based on Friday's reports, Laidi says. Much more important than the trade numbers in the short term, Bernanke will be testifying to Congress on Monday and he'll likely be grilled on all these issues at length.

Rally Fades

Stocks, meanwhile, were mixed Thursday. Strong guidance from electronics retailer

Best Buy

(BBY) - Get Report

provided an early boost, but the market ran out of steam later in the afternoon following a big rally on Wednesday.

Some also attributed the drop to remarks from Chicago Fed President Michael Moskow, who signaled that rates may have to go higher if inflation expectations keep rising.

The

Dow Jones Industrial Average

rose 24 points, or 0.2%, to 10,883, but that was well off an intraday high of 10,952. Dow component

AIG

(AIG) - Get Report

rose after agreeing to a $1.6 billion settlement with the

Securities and Exchange Commission

over its alleged accounting wrongdoing.

The

S&P 500

dropped 0.15% to 1263, off an earlier high of 1274. and the

Nasdaq Composite

fell 0.5% to 2255, off an earlier high of 2284.

Research In Motion

(RIMM)

was higher after the BlackBerry maker said it found a way to continue providing wireless email service should its ongoing patent dispute continue with

NTP

. But weakness in semiconductor issues eventually led the tech sector lower. The Philadelphia semiconductor index dropped 0.3%.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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