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USD Doldrums - State Street Australia

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USD Doldrums - State Street Australia Powered By Docstoc
					Research

Imposing thrift on the US
Harvinder Kalirai Head of Research & Analysis, Asia Pacific

It will take a recession to narrow the US’s current account deficit
World (ex-US) growth
1% 1% 2% $605b (5.4%) $640b (5.6%) $675b (5.8%) $710b (6.1%) $740b (6.3%) 2% $590b (5.2%) $625b (5.5%) $660b (5.7%) $695b (6.0%) $730b (6.2%) 3% $580b (5.1%) $615b (5.4%) $645b (5.6%) $680b (5.8%) $715b (6.1%) 4% $565b (5.0%) $600b (5.2%) $635b (5.5%) $665b (5.7%) $700b (6.0%) 5% $550b (4.9%) $585b (5.1%) $620b (5.4%) $655b (5.6%) $685b (5.8%)

US growth

3% 4% 5%

The current account scenarios are constructed using IMF estimates for US export-income and import-income elasticities of 1.3 and 2.2, respectively, from IMF Staff Country Reports No. 98/105. The figures in brackets are the current account deficits as a percentage of GDP. Forecasts assume a $10bln deterioration in the investment income balance. The forecasts do not include any provisions for a terms of trade shift or the lagged effects of currency movements.
2

1960s & 1970s
1.

US bubble in the “nifty fifty” burst. From late 1968 to mid1970s, the S&P 500 fell 40%. Fed eased policy to cushion the economy. Growing government spending to finance the Vietnam war. US economy rebounded sharply following the mild 1969/70 recession, but became mired “twin deficits”. Bretton Woods collapsed. President Nixon was forced to close the gold window, effectively devaluing the dollar. Oil shock of 1973. This fostered the stagflationary environment of the 1970s. Fed ultimately had to tighten policy as inflation accelerated, leading to the deep 1973-75 recession – peak to trough GDP decline of 3.4%.
3

2.

3.

4.

5. 6. 7.

1990s & 2000s
1. 2.

US tech bubble has burst. The S&P 500 had fallen 45%. Fed eased policy to cushion the economy. Growing government spending to finance the war on terrorism US economy rebounded sharply following the mild 2001 recession, but became mired “twin deficits”. Oil shock of 2004. “Bretton Woods II” (Asian links for the dollar) to collapse? Will this foster a stagflationary-type environment? Will this ultimately force the Fed tighten policy, leading to a recession?
4

3.

4. 5. 6. 7.

The sequence of events
1. US Fed pursues a super accommodative policy stance, weakening the US dollar. 2. China floods its financial system with liquidity to prevent the renminbi from appreciating against the broadly weakening dollar. 3. China “buys” dollars from its exporters, paying them with newly printed renminbi. The renminbi stays in China’s financial system, while the dollars end up in US Treasuries. 4. China reflates its economy, while helping the US by keeping Treasury yields low.

5

Who will “blink” first?
(1) Fed tightens in response to domestic inflation concerns. or (2) Asian central banks refuse to keep importing the Fed’s inflationary policies. The former sees thrift imposed on the US economy internally (i.e. the Fed tightening policy to reign in excess consumption). The latter sees thrift imposed externally - the Chinese and Japanese no longer fund US’s excess consumption (just as the Europeans refused to do in the early 1970s, leading to the breakdown of the Bretton Woods system). Clearly, this will be more disruptive for the US economy and the dollar.
6

Will the Fed be slow to tighten?
10 8 6 4 2 0 -2 -4 1965
1970 recession 1974 recession 1990 recession 1980/81 recession

Will the Fed be slow to tighten?
12 10 8 6 4
2001 recession Still too 2 low !

0 1980 1985 1990 1995 2000 2005

1970

1975

y/y % chg in US GDP (lhs)

y/y % chg in non-energy CPI (rhs)
7

Asian inflation – is it getting too high?
9 8 7 6 5 4 3 2 1 0 Jan-98
New cyclical high!

Asian* inflation, %

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

* GDP weighted average of China, Hong Kong, India, Indonesia, Malaysia, Philippines, S. Korea, Singapore, Taiwan, and Thailand. Shown as 3-mo average of y/y % change in CPI.
8

Asian inflation – Japan and China
y/y % chg in Chinese CPI
10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04
2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 Jan-95

Japanese nationwide core CPI (y/y % chg)

"Dis-deflation"
Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04

9

Consequences of Chinese reval - Asia

1. Allows for a greater appreciation of the Asian regional currencies and the Japanese yen against the dollar.

10

Consequences of Chinese reval - Asia
125 120 115 110 105 100 95 90 85 80 75 Jan-85 Jan-88 Jan-91 Jan-94 Jan-97 Jan-00

Real effective yen (index)

Long-run average Cheap!!!
Jan-03

The yen is still cheap – lots of room for upside!
11

Consequences of Chinese reval - Asia
Asian regional currencies versus the Japanese yen
110 105 100 95 90 85 80 Jan-03
Jan 2003 = 100

Apr-03

Jul-03
THB

Oct-03
P HP

Jan-04
KR W

Apr-04
IDR

Jul-04
TWD

Oct-04

S GD

Asian regionals have been underperforming the yen. Local inflation rates will dictate the amount of appreciation policymakers will tolerate.
12

Consequences of Chinese reval – other currencies
Possibility for contagion, leading to further US dollar weakness against the euro, the Australian dollar, and other major currencies: 1. With a major support for US assets – Chinese purchases of Treasuries – disappearing, investors around the world will become more wary of buying dollars and dollar assets. 2. Japanese yen and Asian currencies are 54% of Australia’s TWI. If they are appreciating versus the dollar, so can the Australian dollar without placing upward pressure on the TWI.
13

Consequences of Chinese reval - commodities
Two forces will be at play: • • Because commodities are priced in dollars, dollar weakness will be supportive for commodity prices. Chinese revaluation that (a) represents a domestic tightening of monetary policy and (b) imposes thrift on the US economy, would ultimately end the global reflation process.

Point #1 may be the initial reaction in commodities as the dollar falls. Point #2 will be the medium term cyclical trend as global growth responds to the policy tightening.
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Consequences of Chinese reval - commodities
800 700 600 500 400 300 200 100 0 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Gold, $/oz (lhs ) Tra de -we ighte d dolla r inde x (rhs )
15

Inverse relationship between gold and the US dollar

180 160 140 120 100

`

80 60 40 20 0 Jan-05

Massive terms-of-trade shifts may be underway
112 107 102 97 92
+40%

Canadian terms of trade index*
+50% 130

Australian terms of trade

120

110

100
87

90
82
*Shown as 3-mo moving average

77 Jan-70

Jan-75

Jan-80

Jan-85

Jan-90

Jan-95

Jan-00

Jan-05

80 1970

1975

1980

1985

1990

1995

2000

2005

N Z te rm s o f tra d e
145 135 125 115 105 95 +55%

Note: vertical lines represent the peak in the US dollar in 2002 Q1.

85 75 1970

1975

1980

1985

1990

1995

2000

2005

16

Consequences of Chinese reval – the US
1. A Chinese reval will impose thrift on the US economy. China becomes less willing to fund US’s excess consumption by purchasing Treasuries. 2. Rise in US import prices and inflation. 3. Rising inflation + slower growth = stagflation 4. Upward pressure on US yields. 5. Renminbi revaluation itself may not have a big impact on the US’s trade deficit – US does not compete with the goods it imports from China. But slower US growth (recession?) and stronger currencies in the rest of Asia should help to narrow the US’s trade deficit.
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Who will fill the hole?
Foreign official flows to the US (% of GDP)
3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 Q1 1970
Shown as 4-qtr moving average

Early 1970s dollar decline.

Late 1970s dollar decline.

Unprecedented!
Mid-1990s dollar decline. Late 1980s dollar decline. Late 1998/99 dollar decline.

Early 1980s dollar rally.

1997/98 dollar rally.

2000/01 dollar rally.

Q1 1975

Q1 1980

Q1 1985

Q1 1990

Q1 1995

Q1 2000

Q1 2005

Estimates for 2004 Q3 based on the Fed's custody holdings.

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Still not undervalued
US dollar real effective exchange rate
130 125 120 115 110 105 100 95 90 85 80 Jan-72 Jan-76 Jan-80 Jan-84 Jan-88 Jan-92 Jan-96 Jan-00 Jan-04 Pos t-Bretton Woods average

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When will it end? After a recession, a narrower current account deficit & an undervalued dollar
y/y % chg in real US GDP
10 8 6 4

1

2 3 1 2 3?

2 0 -2 -4
1960 1965 Mild recession Deep recession? Deep recession 1970 1975 1980 1985 1990 1995 2000 2005
20

Mild recession

Fed policy: then & now
Real Fed Funds Rate, %
8 6

3
4

1. Deflating the bubble. 2. Reflating the bubble. 3. Dealing with the inflationary consequences.
5

1
2

2

0

-2

Real Fed Funds Rate, %

-4 Jan-60

Jan-62

Jan-64

Jan-66

Jan-68

Jan-70

Jan-72

Jan-74
4 3 2 1 0 -1 -2 Jan-90

1 2 3?

Jan-92

Jan-94

Jan-96

Jan-98

Jan-00

Jan-02

Jan-04

21

The dollar and current account, then
US current account (% of GDP)
1.5
Slight improvement in the US's current account during the mild 1969/70 recession.

1.0

0.5

1 3 2
After the 1969/70 recession, the US current account deteriorated amid the policy reflation. The US current account swung around sharply after the Fed tightened policy aggressively and pushed the economy into a deep recession. Also, the lagged effects of prior dollar weakness were being felt.

0.0

-0.5

-1.0

USD TWI
125
Improving current 120 account and high real rates allowed the 115 dollar peg to continue.

-1.5 Q1 1968

Q1 1970

Q1 1972

Q1 1974

Q1 1976

1

110 105 100 95 90

The dollar rallied almost 15% once the Fed pushed US real rates higher and the current account deficit narrowed as the economy fell into a deep recession.

2
Even though the economy rebounded following the 1969/70 recession, the dollar weakened as policy reflation continued.

3

Jan-70

Jan-71

Jan-72

Jan-73

Jan-74

Jan-75

Jan-76

Jan-77

22

The dollar and current account, now
US current account (% of GDP)
-3.0
Slight improvement in the US's current account during the mild 2001 recession.

-3.5

-4.0

1

The US current account should swing around sharply after the Fed tightens policy aggressively and pushes the economy into a deep recession. Also, the lagged effects of prior dollar weakness will then be felt.

-4.5

2
-5.0
After the 2001 recession, the US current account deteriorated amid continued policy reflation.

3?

-5.5

USD TWI
-6.0 Q1 2000
125

Q1 2001

Q1 2002

Q1 2003

Q1 2004

Q1 2005

Q1 2006
115

1
105
Improving current account and high real rates supported the dollar, as the economy fell into recession.

The dollar should recover once the Fed pushes US real rates higher and the current account deficit narrows as the economy falls into a deep recession.

95

2
Even though the economy is rebounding following the 2001 recession, the dollar weakens as policy reflation continues.

3?

85

75

Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

23

The dollar’s fundamental problem
-6.0 -5.0 -4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 1970

US real rates & the current account
9.0 7.5 6.0 4.5 3.0 1.5 0.0 -1.5 -3.0 -4.5 1975 1980 1985 1990 1995 2000 2005

Current account, as % of GDP, inverted scale (lhs)

Real 10-yr US yields, % (rhs)

Unprecedented divergence between US real rates & the current account.
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Conclusions
1. A narrowing of the US’s current account deficit requires increased thrift (savings) by the US economy. 2. The problem is that this will not occur spontaneously. The process needs a catalyst. The catalyst will be a weaker dollar. 3. Higher import prices and higher interest rates (as Asian stops buying Treasuries) will impose thrift on the US economy. 4. On the other side, as their currencies appreciate, the Asians (and perhaps even the Europeans) will be forced to stimulate domestic demand. 5. In the end, global imbalances will adjust, but only with the “stick” of a falling dollar.
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