Devil in Deficit Details

A narrowing gap boosts the dollar but may also signal a slowing of U.S. economic activity.
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It was the classic setup. Sentiment was negative against the dollar just ahead of the November trade deficit numbers and the expected hawkish comments from the European Central Bank. Therefore, the dollar took off after better-than-expected numbers and comments.

In recent action, the euro had dropped 0.8% to $1.2033 vs. $1.2116 late Wednesday while the dollar was trading at 114.26 yen vs. 114.13, rebounding from its lowest levels since October.

The U.S. trade deficit narrowed to $64.2 billion in November from a downwardly revised $68.1 billion in October. The consensus of Wall Street economists was for the November deficit to narrow to $66 billion from the originally reported $68.9 billion.

The narrower deficit was mostly due to the lower dollar value of oil imports in November. The price of oil, which is dollar-denominated, was pressured as the U.S. currency rose that month. The deficit also improved thanks to aircraft exports from

Boeing

(BA) - Get Report

, and as U.S. retailers imported less from the likes of China in anticipation of a sluggish holiday shopping season.

Also boosting the dollar Thursday were dovish comments from European Central Bank President Jean-Claude Trichet after the ECB left interest rates unchanged.

The ECB delivered its first rate hike in five years in December. Trichet was expected to make a hawkish speech, signaling that another rate hike is in the cards given recent signs of economic strength in the eurozone.

Instead Trichet said the ECB is "weighing" risks to both inflation and growth, according to Bloomberg. Speaking at a press conference, he said that risks to growth "were on the downside."

Yet dollar gains were mostly a reaction to the greenback's weakness over the past month, says ABN Amro currency strategist Greg Anderson. Currency traders have so far this year successfully bet against the dollar, which has fallen 1.6% vs. the euro and 3.1% vs. the yen year to date.

"Now, we've likely entered a period of consolidation of the dollar selloff," says Anderson.

Fundamentally, the improvement in the November trade deficit does little for the dollar. First, the deficit is still the third-largest on record. Second, the improvement was mostly due to lower oil prices, which have since rebounded.

Indeed, rising oil prices were putting pressure on stocks Thursday. In recent action, the

Dow Jones Industrial Average

was falling 42.89 points, or 0.4%, to 11,000.55. Blue chips were weighed down by

General Motors

(GM) - Get Report

, amid concerns it may cut its dividend due to pressure from private investor Kirk Kerkorian.

Coca Cola

(KO) - Get Report

and

JPMorgan Chase

(JPM) - Get Report

also were weighing on the Dow following broker downgrades.

The

S&P 500

index was recently down 0.23% at 1291.25 and the

Nasdaq

was down 0.27% at 2325.13.

Third, a continuation in the deficit improvement would be dependent on global growth fueling U.S. exports.

If Trichet's comments are to be taken at face value, that's not very good news for U.S. exports. If they're not, the ECB will continue to boost rates, narrowing the yield differentials with the U.S.

At 2.25%, the eurozone key rate is still below the fed funds rate at 4.25%. Advantageous yield differentials, including with Japan's near-zero rates, supported the dollar last year. But things have changed now that the

Federal Reserve

has signaled that the end of its 18-month-long rate-hike campaign may be in sight.

And in terms of currency flows, the trade deficit is not about to improve, which would boost demand for dollars. On the contrary, according to Jay Bryson, global economist at Wachovia. "Because imports are nearly twice as large as exports, the latter must grow almost twice as fast as the former simply to stabilize the deficit," he wrote.

To play devil's advocate, the narrowing of the November deficit even may signal economic troubles down the road.

According to Joel Naroff, president of Naroff Economic Advisors, the U.S. deficit with China is still on track to top the $200 billion mark in 2005. China's exports to the U.S. would only slow dramatically if U.S. consumption were to slow drastically.

The November deficit included an improvement of the U.S. deficit with China, and the trend may continue because a slump in auto sales is expected to have cut fourth-quarter U.S. consumption and growth. Meanwhile, the overall U.S. trade deficit is still expected to have reached 6% of GDP in 2005.

"Trade is likely to restrain growth, and with consumption soft, the GDP growth rate could be a lot less than most people are currently thinking," Naroff says. He predicts GDP growth risks falling to 2% or less in the fourth quarter after growing at a 4.1% rate in the third quarter.

That's good news for those hopeful that the Fed will stop lifting interest rates sooner rather than later. But that's not likely to be good for the dollar. For the stock market, the jury is still out.

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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