THE BULLISH CASE FOR THE US DOLLAR
The rally of the dollar is having an impact on the macroeconomic indicators of countries from Europe to the Indian subcontinent. It also puts a spanner in the works for oil prices and the northward movement of goods

By Matein Khalid

The dramatic breakout in the dollar was inevitable given the $30 plunge in crude oil since mid July. In essence, the foreign exchange markets have priced in a global economic slowdown and shrinkage in the US trade deficit that benefits the dollar. Moreover, the European Central Bank (ECB)’s Jean-Claude Trichet and the Bank of England’s King retreated from their previous hawkish stance on inflation and emphasised downside risks to economic growth.

As US gasoline and jet fuel demand plummets alongwith tight monetary policies and the elimination of fuel subsidies in Asia, there is no reason to doubt that crude oil prices can fall below $100. It was significant that not even a war in Georgia, a pipeline and storage hub of Caspian Sea oil could derail the bearish momentum on crude oil. This is in stark contrast to the period only three months ago, when any geopolitical risk (Iraq, Niger Delta, Venezuela, US-Iran nuclear threats) would instantly cause a $3-5 barrel spike in oil prices.

The greenbacks rally
The magnitude of the dollar’s rally suggests a trend reversal has now taken place. Not only did the Euro and the British pound plunge beneath their 200 day moving averages, a key technical support point. Commodity currencies like the Aussie dollar, New Zealand dollar and the Brazilian real have all plunged in value. The Australian dollar has lost 10 per cent as commodities are sixty per cent of exports and the Reserve Bank in Canberra has indicated economic softness will force a rate cut as early as next month, removing its high yield advantage.

There is increasing evidence that the commodities bull market is now over. Commodities across the spectrum – gold, silver, corn, wheat, grain, lead, nickel, copper have plunged in unison. In essence, the Chindia/Peak Oil argument has proven a dangerous illusion when growth slowed, demand curves shifted and commodities index funds scrambled to liquidate their long positions. There is also increasing pressure on the ECB to soften its hard money policy as consumer confidence plunges in the Eurozone. While Trichet’s mandate is to control inflation and not growth, he cannot remain indifferent to the chorus of outrage in Berlin, Paris, Rome and Madrid. So another ECB rate hike is out of the question as long as economic data disappoints. Both the ECB and the commodities outlook suggests the dollar rally will continue. A 1.38-1.40 year end target on the Euro is achievable. The caveat to the dollar rally would be more Wall Street banking distress, a U-turn in oil prices, a surprise Fed rate cut, economic recession in the US and additional weakness in housing. These can all derail the dollar bulls this autumn.

The Indian connect
The Indian Rupee is headed lower against the dollar. The Manmohan Singh government has made a serious mistake in giving wage hikes to 5mn government employees at a time when the Reserve Bank of India had done its best to dampen inflation. This was the reason the RBI had hiked the banking system’s cash reserve ratio (CRR) and repo rate so aggressively since June. Inflation has now soared to almost 12.5 per cent, its highest level since the early 1990’s. A wage hike now adds to the fiscal burden on the eve of a election the Congress could well lose because inflation causes incumbent parties to lose, the lesson of the opposition Bharatiya Janta Party’s victory in Karnataka.

The RBI has no choice but to hike interest rates even more to offset the fiscal largesse. Another repo rate and CRR rate hike is now inevitable. After all, the RBI’s seven per cent target inflation rate is impossible without significant monetary tightening. Inflation can well rise to 14 per cent as prices of pulses, spices, diesel, liquid petroleum gas and fruits are still moving higher. Meanwhile, the Sensex can easily fall to 10,000 as global fund mangers sell Indian shares. Industrial production has plunged from 10 per cent last summer to five per cent now and bank credit growth will fall, corporate profit margins will be squeezed and FII money will flee the Indian market as global risk aversion against emerging markets rise. I anticipate Indian bond yields to rise from 9 per cent to 12 per cent. A wage-price spiral as India now faces the kiss of death for its nascent bond market. This makes the Indian rupee a compelling short, with a target of 45 rupee against the dollar by October.

Sterling has been mauled in the FX markets after Bank of England Governor Mervyn King admitted to a “Chill in the economic air” and predicted that inflation will fall to his target two per cent in two years if the base rate remains unchanged. Britain has flashed a recession SOS. The banking system is gutted after the US financial crisis. The High Street is leveraged as never before in the history of the realm. Gordon Brown’s public finance black hole is a disgrace. Britain faces its worst recession since the early 1990’s – and the Bank of England will be forced to cut rates as low as three per cent next year. Sterling calls then fall as low as 1.75 by next summer, when New Labour next faces the electorate. Financial markets have only just begun to price a bearish scenario for sterling.

The author is a renowned investment banker based in Dubai.
 

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