The recent decline in US interest rate expectations contrasts with those for the eurozone and for Japan. That said, the dollar has this far held up well on the foreign exchanges, performing more robustly than we or many market participants had expected over the past two years. There are several possible reasons for this which include the possibility that interest rate differentials are not the only thing that currency traders look at and the hope (it is Charles Stanley’s central expectation too) that Fed policy makers can guide the US economy to a soft landing with only modest base rate reductions. Whilst this might represent the optimists’ best case we take the opportunity to consider the risks to the cosy continuation of the status quo.
With regard to rate differentials the outlook does look pretty benign judging by the mixed nature of recent data releases. Top down strategists are particularly concerned about the outlook for US consumer spending in the light of the recent collapse in the residential property market. They also point to a possible deterioration in the already bleak US trade position. However, these concerns are counterbalanced to some extent by the recent weakness in the oil price which has resulted in a revival in consumer confidence and helped to take the immediate pressure off the dollar as the trade deficit has narrowed from earlier record levels.
Furthermore, the decline in US interest rate expectations is consistent with the view that the Fed’s Open Markets Committee can guide the US economy by making only small adjustments to prevailing base rates. The support that this has provided to general confidence in the US economy and US asset prices has encouraged the view that the long upswing in activity can be sustained. This, in turn, has helped to support the currency as global asset managers retain their support for the greenback. It is notable in this context that Charles Stanley’s forecast for US growth over 2007 is 2.4%, not far away from the current consensus 2.6%.
We wonder, however, how much this consensus may yet have to fall as a confluence of growth-negative factors begins to manifest itself in data releases from early next year. Specifically we note the extent to which lower oil prices are currently providing a boost to growth. Our expectation is that the oil price may slip back to around $55 per barrel next year, a decline from prevailing levels but nothing like the decline experienced from peaks earlier this year when fears of a conflagration in the Middle East (which can hardly be said to have eased) encouraged some to speculate on $100 per barrel oil and helped to drive the price, in nominal terms, to $80 per barrel. Put differently, the boost to confidence from an ebbing oil price may now have run its course.
By contrast, the full impact of the downturn in the housing market has yet to be felt.
We suspect that the confluence of rising unemployment, falling consumer confidence, falling consumer spending and falling business investment could actually result in US growth coming in well below consensus levels, possibly down to as little as around 1.5% – 1.6%. With little room to manoeuvre in terms of fiscal policy it is likely to be down to the Fed to use base rates to try and engineer a “soft landing” in an environment in which a technical recession, at the very least, may be perilously close at hand. We suspect that the early part of 2007 could be characterised by nervousness regarding the Fed’s ability to drive the supertanker away from the rocks. With every FOMC meeting that passes, so concerns are likely to grow. Even if policymakers elect to hold rates steady futures pricing is likely to anticipate base rate cuts over the months ahead, removing a massive prop to the currency.
With investors continuing to fret that the 2006 oil price decline to prevailing levels, coupled with uncertainty regarding how containable the housing market slowdown might be, we suspect that the dollar will take its view from altered forward expectations and resume its slide both against the euro and the Yen. Sterling, as ever, is likely to be hamstrung between a weak dollar and robust euro which may encourage cable to 1.94 although a return to the much hyped 2.00 can’t be ruled out if US activity levels disappoint. More dramatic currency movements are likely elsewhere with the dollar falling to around 1.40 against the euro and about 98 against the Yen.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley