U.S. dollar: cyclical strengths vs. structural weaknesses; Traders often learn that interest...

In explaining his three-year old short dollar position, billionaire investor Warren Buffett told shareholders earlier this year, "There are deep-rooted structural problems that will cause America to continue to run a huge current-account deficit." He added, "Our [U.S.] economy is far and away

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Buffett's emphasis on the dollar's "structural" concerns of current account and fiscal imbalances continue to take precedence over the United States' cyclical superiority of higher growth and increasing interest rates.

Yield differentials have long been used as a basis for explaining currency moves on the rationale that higher yielding currencies are boosted by yield-hungry foreign capital. But this theory is refuted by "Dollar reactions to Fed tightening" (right), which shows the dollar to have fallen in three out of the seven tightening campaigns of the Fed since the mid 1970s. Factors such as trade and fiscal balances, government currency policies and competing foreign environments also were at play shaping the nation's currency.

The power of market expectations is a key consideration worth bearing in mind when measuring yield differentials. The bulk of the 2004 dollar gains occurred in the first three months of the year in anticipation of higher U.S. interest rates, rather than during the actual rate hikes, which started in June.

By the time the Fed started raising rates, currency markets had already priced-in those moves and hedge funds had kicked off their carry trades prior to the actual rate moves so as to better position themselves for maximum currency gain and yield pickup. The phase of the tightening cycle also is crucial. The dollar is apt to generate heftier gains before the start of the tightening campaign when interest rates are below other currencies rather than in the midst of the tightening cycle when U.S. rates are already above their foreign counterparts.

Yet there is more to the yield-dollar picture than merely yield differentials with other countries. Our study shows that the U.S. yield curve served as a decent indicator of the dollar's major moves. A more effective way of following the steepness/flatness of the U.S. yield curve over time is through the yield spread between two- and 10-year Treasuries.

The six rate hikes from June 2004 to February 2005 have lifted two-year yields to a three-year high of 3.50%, while maintaining 10-year yields near their three-year weekly average of 4.30%, before a more recent 4.50%. In contrast, the two-year note's weekly average over the same three-year period (January 2003-February 2005) stands at 2.27%, well below the current rate of 3.70%. This has resulted in an 18-month decline in the spread between the two yields (10-year/two-year), reaching 0.8%, the lowest spread since April 2001.

"Falling yield spreads weigh on dollar" (right) cogently illustrates the two episodes of a falling dollar during periods of narrowing yield spreads emerging from Fed tightening. The first episode ensued during the aggressive Fed tightening between February 1994 and June 1995, which slashed the 10-year/two-year spread from 1.5% to 0.45%.

The 2003-04 Fed tightening cut the spread from 2.1% to 0.78%. Short-term rates rallied thanks to the Fed hikes while long term yields remained mostly stable due to Asian purchases of U.S. Treasuries, benign inflation (according to government figures) and an uncertain growth outlook. Long-term rates remained stable on the rationale that the Fed's tightening was aimed at normalizing monetary policy rather than containing an overheating economy, in which case currency traders offered very little growth reward to the U.S. dollar.

The other reason for the dollar's struggle in the face of higher rates was the Bush Administration's de-facto weakening of the dollar. Not only have the U.S. Treasury and a few congressmen been pushing for a revaluation of China's currency, but the administration also was reluctant in stabilizing the dollar's decline.

Benign neglect of the dollar was a major driving force in 1994 when the 300-basis points of Fed tightening between February 1994 and June 1995 led to a 5% drop in the dollar's trade-weighted average due to the Clinton administration's quasi-trade war with Japan. The administration adopted a resounding policy of talking down the dollar, pressing Japan to open its markets of semiconductors and automobiles.

BUDGET WOES

One aspect of the swelling U.S. budget deficit that is rarely mentioned in the media is the continued shortening in the maturity of U.S. debt. The shorter the debt, the higher the risk of investors rolling off the debt (as opposed to rolling it over).

Unlike Mexico or Turkey, the U.S. government debt is in its local currency; thus, the Treasury can simply print dollars to meet its obligations. Yet, as we saw in the summer of 2003 from the Fed's reflationary policy, incessant currency printing means a flood of liquidity and downward pressure on the dollar.

According to the latest data, the average maturity of outstanding U.S. debt fell from 65 months in the first quarter of 2002 to about 55 months in the fourth quarter of 2004. Falling interest rates in 2001-03 encouraged the Treasury to borrow short-term rather than long-term to reduce the cost of government debt. With non-U.S. holders of U.S. debt preferring shorter maturities due to their relative ease of disposal, the U.S. Treasury had no choice but to accommodate non-U.S. demands (see "Debt maturity measures," page 50).

Although there have been no signs of difficulty in the foreign financing of U.S. debt, the portion of non-U.S. debt relative to that of the trade deficit does merit scrutiny. As of February, 53% of outstanding U.S. government debt was owned by non-U.S. countries and 29% was from international central banks. Falling duration of maturity also reflects non U.S. countries' unease with a long-term commitment to a paper whose currency is on a constant decline.

Faced with a falling dollar on one hand and higher rates on the other, investors must weigh the trade-off between yields and currency returns. Central banks are mostly chasing short-term yields to maturity, especially now that two-year Treasuries offer the highest rates in three years.

But investors also know that higher rates are raising the cost of debt. Last year Congress approved raising the federal debt limit by $800 billion to $8.18 trillion, accumulating $2.23 trillion in total ceiling increases over the past three years. As long as the administration takes no concrete measure in expanding its tax base, its reliance on cutting discretionary spending will not only be politically unviable but fiscally marginal.

OIL-TRADE VICIOUS CIRCLE

Being the world's largest importer of oil and using a widely depreciating currency, the United States' dependence on the fuel has contributed to a vicious circle of rising oil imports, a deteriorating trade gap and a falling currency. With the impact of rebounding oil prices expected to hit the trade balance in the first quarter, we could see a negative oil trifecta weighing on consumer spending, business spending and net trade (exports minus imports).

Saudi Arabia's oil minister Al Naimi and acting OPEC secretary general Shihab-Eldin roiled oil prices in March when they indicated that $50 oil could no longer be seen as an anomaly and even hinted prices could reach as high as $80 in the next two years.

Commercial oil stocks at the Organization of Economic Cooperation and Development (OECD) dropped 85 million barrels to leave end of December forward demand cover at 51 days. The forward demand cover in 2005 is projected to drop to a low of 48 days. In 2004 total OECD demand rose 3.2% to 82.2 million barrels and is forecast to grow by another 3.0% to 84.7 million barrels per day in 2005 while total supplies (including non-OPEC) are expected to amount to 84 million barrels, producing a shortfall of 0.7 million.

The negative relationship between oil and the dollar is especially highlighted by its validity regardless of causality. A falling dollar is seen as oil positive because oil producers will require higher prices to overcome the declining value of the U.S. Dollar--the invoice currency.

Conversely, higher oil raises the price of U.S. oil imports and further fuels the widening trade deficit. The impact of oil imports on the trade deficit is illustrated in "The oil, deficit connection" (left) showing that monthly U.S. imports of petroleum products (crude oil and other energy-related items) as a percentage of total monthly imports doubled to 13% between January 2002 and December 2004.

In 2004, the monthly increase in imports and exports averaged 1.3% and 0.9%, respectively. If we expect the 2004 average trend growth in imports and exports to continue, then the trade deficit would surpass the $70 billion mark by the third quarter.

So far, the falling dollar has had no impact in stabilizing the widening trade deficit. It is this stark reality of higher oil prices that disrupts the theoretical relationship between a weak currency and a nation's trade balance. Despite the 33% drop in the dollar's trade-weighted index between 2002 and 2004, the trade deficit soared 90% through the same period. Besides importing about 20% of the world's exports, the United States imports are about 60% greater than exports. With no signs of the current trend stabilizing any time soon, the swelling trade gap shows no signs of reversal.

The expanding trade gap also hurts the dollar via its impact on overall economic growth. In the first quarter of 2004, negative net exports (export minus imports) dragged down real GDP growth by 1.43%, shedding the largest share off the economy since the second quarter of 1998. Just as it can be argued that a falling dollar is a catalyst to higher oil, rising oil prices ($50-$60 per barrel) exacerbate the U.S. trade gap, thereby pushing currency traders away from the dollar. As long as the interconnection remains, there is little hope for a falling dollar to halt the growing trade imbalance.

CENTRAL BANK DIVERSIFICATION

We have all heard the reports in February from South Korean and Japanese officials denying that they were diversifying their foreign exchange holdings and selling dollars and buying euros.

While the central banks said they were not selling U.S. dollars, they never confirmed they were buying other currencies. Those semantical maneuverings were largely aimed at stabilizing the dollar.

Naturally, the world's leading central banks are unlikely to start selling their dollar holdings mainly due to the negative impact on the U.S. currency, and on the value of these holdings, such sales would elicit. That also would mean undesirable upward pressure on their own countries' currencies. But it's also worth noting that a slower rate of accumulating new dollars coupled with increased purchases of other high-yielding currencies (British pound, Australian dollar) is sufficient to weigh on the dollar the next time these data are reported. Also bear in mind that a falling dollar erodes the value of these central banks' Treasury holdings and is, therefore, a de-facto reduction in U.S.-denominated securities.

While Russia, South Korea and even Thailand have hinted at diversification, Japan remains the biggest owner of U.S. Treasuries with more than $840 billion in currency reserves and more than $700 billion in U.S. Treasuries. It is far from an aberration that Japan's accumulation of Treasuries fell in four of the five months between September and January in response to a 30% drop in the value of the dollar.

"Japan fades, hot money rises" (above) shows how the once stable Japanese holdings may be giving way to holdings by unreliable hedge funds. And, the fact that a single line from South Korea's central bank's report had shaken the markets is a reflection of a prevalent fear emerging from the dollar's stark realities rather than fickle trader sentiment.

The balance between the structural deficits and the growth/yield advantages of the U.S. dollar is increasingly tipping toward the side of the structural concerns mainly because of their deteriorating pace and their long-term nature. Currency traders can do little with higher growth rates but are better able to exploit the widening in the dollar's yield advantage or a narrowing in its yield disadvantage.

Yield opportunities are relatively short-lived depending on temporary swings in expectations of further Fed tightening. Once these shifts in expectations dissipate, the structural deficiencies take over eliciting the status quo of negative dollar sentiment. The pace of faster twin deficit deterioration relative to the rate of U.S.-bound flows remains exacerbated by high oil prices and a growing apprehension by non-U.S. investors to hold U.S. dollars.

RELATED ARTICLE: DOLLAR REACTIONS TO FED TIGHTENINGS

The value of the U.S. Dollar is driven by more than just interest rates. Here's evidence that other factors can force the dollar lower even during periods of Fed tightening.

                  Fed Funds       % Change      Cause of U.S. dollar
Tightening Cycle  Rate Range (%)  in USD Index  move

Nov 76-Oct 79     4.75-15.50      -7.2          USD struggles after
                                                Treasury Secretary
                                                Blumenthal aggressively
                                                talked down USD in 1977.
Aug 80-Jan 81     9.00-20.00       3.1          USD begins five-year
                                                takeoff as rates hit
                                                20%, BoJ & Bundesbank
                                                cut rates.
May 83-Aug 84     8.50-11.75       8.9          USD extends rally as
                                                foreign capital influx
                                                chases U.S. assets.
Apr 87-May 89     6.00-9.75        4.8          USD edges up after
                                                Louvre Accord aims at
                                                stabilizing USD plunge.
Feb 94-Jun 95     3.00-6.00       -5.1          U.S.-Japan trade War
                                                hits dollar. Fed seen
                                                behind curve in
                                                combating inflation.
Jun 99-Dec 00     4.75-6.50        3.4          USD driven by high
                                                growth, low inflation,
                                                equity market boom.
June 04-Feb 05    1.00-2.50       -5.8          USD driven by twin
                                                deficit deterioration,
                                                capital flows concerns.

Source: MG Financial Group

RELATED ARTICLE: FALLING YIELD SPREADS WEIGH ON DOLLAR

While not the only factor, periods of tightening yield spreads can certainly impact the value of the dollar.

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Source: MG Financial Group, Federal Reserve

RELATED ARTICLE: DEBT MATURITY MEASURES

Purchasers of U.S. debt have been favoring shorter and shorter maturities in recent years.

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The average maturity of issuance is the ultimate average maturity achieved if coupon issuance in any given quarter is held constant going forward and the balance of financing needs are met with changes in bill issuance. (4 quarter moving average).

Source: U.S. Treasury

RELATED ARTICLE: THE OIL, DEFICIT CONNECTION

As oil imports increase as a percentage of the GDP, we can expect the trade deficit to widen.

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Source: MG Financial Group, U.S. Department of Commerce-BEA

RELATED ARTICLE: JAPAN FADES, HOT MONEY RISES

Japan is slowing down its trade in U.S. dollars, but hedge funds are stepping in to take its place.

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Source: MG Financial Group, U.S. Treasury

Ashraf Laidi is the chief currency analyst at MG Financial Group, an online currency trading firm. E-mail: ashraf@mgforex.com.