Overview
The Treasury capital flow report last week was wildly dollar-favorable, an inflow of $87.4 billion in July
after a revised $80.9 billion in June, or $168.3 billion in just two months. With the Fed finding no reason
in any of the data, known or expected, to pause on the road to "neutral," the dollar should be the
beneficiary of a yield differential with Europe and Japan that is irresistible. We think the world is starting
to accept that the US structural imbalance is acceptable and that the cure for fixing it would be worse than
the disease, if disease it is. For one thing, billions of people in China, India and elsewhere in Asia would
be thrown onto the streets if the US consumer altered his propensity to consume. This is the sense in
which the US has the upper hand, not the holders of US paper in reserves.
Then there is the issue of the hurricane in the Gulf and the enormous deficit spending churning along in
its wake. Fiscal conservatives are outraged, but at the same time, government spending on this scale is
always stimulative. Growth and output lost to the storm will probably be more than made up by new
housing construction, road-building, and so on. The real issue is that the US has an energy crisis--demand
for refined products pressing capacity to the hilt--that it will not acknowledge. In recent years, doom-
sayers like Pete Peterson have said that this exact version of the energy crisis will bring the US to its
knees, but so far the rest of the world is willing to bail out the US by releasing stockpiles. And if that
doesn't work for long, there is always government regulation of the energy markets, which are inarguably
infested with speculators. We need speculators to provide liquidity, but most experts have been saying for
some time that as much as $20 of the price, or a little under a third, is due to rank speculation. Nobody
today expects regulation that would inhibit speculation, but it's an obvious "solution" and maybe we
should expect it.
The Fed is the key to the fate of the dollar, and the market has renewed faith in the Fed's resoluteness in
fighting inflation. If inflationary pressure from oil prices is really rising, and it's hard to see how it can
fail to have second-round effects, then the neutral real rate is rising, too. Instead of imagining that the Fed
will pause, we should be projecting that the campaign of raising rates is going to be longer-lived and take
the rate higher. We say the Fed is going to raise rates at all three of the remaining meetings this year, and
will make strong statements about fighting inflation, too (while denying it is much of a problem). The Fed
will downplay the energy crisis and the effects of the hurricane. Going into Q1, the Fed will still be in
hiking mode, and we won't get a change in rhetoric unless and until some very bad growth and growth-
related numbers start to appear--which they will not, if federal spending is as stimulative as seems likely.
Besides, Greenspan seems to be a born-again fiscal hawk, and has to care about his legacy. He won't
want to be known as the central bank leader who cut rates to 1% and gave a nod of approval to tax cuts
that then ended in ruinous deficits that had to be monetized.
For better or worse, developments in the US dominate the euro/dollar rate. We had a flurry of euro
pessimism on the prospect of a grand coalition in Germany that would be the same thing as gridlock, but
that's a temporary item. Far more important is the authentic public debate about whether reform of the
welfare state proceeds, and how. Europe does "get it," or at least Germany does, if the French and Italians
do not--and Germany leads. Once the wheels of reform start to turn, it's almost impossible to stop them.
This is the main reason to feel optimistic about Japan, too. Right now the only country with an
imaginative and decisive leader is Japan, the country supposedly least hospitable to non-conformists.
And yet, painfully slow change away from smothering Big Brother government is a confidence factor, not
a sufficient cause to re-direct investment flows to Europe and Japan. The US has only one competitor on
that score--emerging markets in Asia, especially China. Repressive regimes, however, never possess
economic and financial leadership. People are too fearful, and rightfully so, of expropriation.
Finally, we thought we would check out what the Big Mac index is saying about the relative purchasing
power of the euro and dollar. The most recent piece on The Economist's website is from January this year,
when the euro was at 1.2200--a nice coincidence. At that time, the euro was overvalued by 17% and
"should," to equalize the cost of a Big Mac in both regions, fall to $1.05.
So, we have a winning combination--a rising real rate of return favoring the dollar and some measure of
overvaluation on the part of the euro. Lots of things can go wrong with this view, including some new
bone-headed action on the part of the US government, a big act of terrorism, Greenspan getting run over
by a truck, and so on. These are the unforecastables, and we admit that when they hit, they tend to be
dollar-negative, revealing the market's long-term bias against the dollar. But right now, the sun is shining
on it.
Technical Notes
On the euro chart, the top of the channel was broken at the time of the New Orleans catastrophe, but the
euro is now inching down again. As of this writing, the break of the red support line is not terribly
convincing, so we can still get a bounce up to resistance at 1.2550 (and declining as the triangle
develops).
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