New Year ... New Dollar?

In 2007, the Dollar had its worst year in recent memory. As the housing crunch and credit woes gripped the U.S. economy the dollar's long slide picked up momentum. This culminated in a record-breaking rout of the dollar toward the end of the year. In November the dollar fell to a record low against the Euro, with the British pound reaching a 26-year high and the Canadian trading a levels not seen in a century. When the dust settled at year's end, the Euro had gained 9.6% against the dollar, while the Canadian picked 14.8% in value. Although the gains were not as dramatic, the Yen settled 6.4% higher on the dollar when the ball dropped on the new year.

The main reason why we have seen such remarkable strength in the Canadian and Euro is not because of stellar economic conditions in Canada or Eurozone, but because of the deteriorating economic conditions in the US. Although the housing market had been struggling for months, its true problems did not surface until the third quarter. Bad loans, particularly in the sub-prime sector, increased significantly, and in late June, leading banks on Wall Street began to report major losses for their hedge funds. In July, AXA Investment Managers closed one of its funds to new investors, BNP Paribas suspended three of their funds, Goldman Sachs was forced to rescue one of their funds and Sentinel, a major US money manager halted redemptions. A snowball affect was seen across the financial markets creating a liquidity crisis that forced the European Central Bank and the Federal Reserve to pump billions into the financial system. The subprime crisis then went global, hitting hedge funds and mortgage lenders in countries like Germany, Australia and the UK. Australian mortgage lender RAMS Loans Group saw its shares crash 60 percent in the middle of August as the US credit squeeze left the lender unable to refinance $5 Billion in debt.

Unsurprisingly, this chain reaction led to a wave of layoffs in the financial sector. America’s biggest mortgage lender Countrywide Financial cut 12,000 jobs. Citigroup warned of 60 percent earnings drop in the third quarter while UBS disclosed $3 billion worth of losses. In the month of August, non-farm payrolls fell by 4k, the first drop in four years. Consumer confidence fell to a 2 year low, driving retail sales excluding autos down 0.4 percent. All of these factors stoked fears that the US economy could fall back into a recession. The risk as well as the conditions in the credit markets and the deterioration in economic data forced the Federal Reserve to cut interest rates for the first time since 2003, but the tables turned in October.

The credit markets began to stabilize, the spread between US Treasury and junk bonds receded from its highs, the stock market rebounded 800 points following the interest rate cut and the non-farm payrolls report for the month of September signaled stability in the labor market. All of these factors have shifted the market’s expectations for future interest rate cuts significantly. Fed fund futures went from pricing in 50bp of easing by the end year to only 25bp by Christmas.

When a central bank lowers or increases interest rates after remaining on hold for many months, their first action is usually not their last. In the case of the Federal Reserve, they have cut interest rates after remaining on hold for the past year and we still expect them to deliver more as we come into the new year. The losses already booked by several major banks including conservative institutions such as the Swiss-based UBS and Wells Fargo do not bode well for the future of the financial markets. The housing market is already in a downward spiral as inventories rise while new, existing and pending home sales continue to decline. The retail figures following the Christmas shopping season are not yet finalized. But from all preliminary reports, the outcome figures will be substantially less than expected. This means that we will see continued slippage in the stock market, which in turn embolden the Fed to continue cutting rates. As this happens, the dollar will continue to weaken against it major counterparts.

Inflation pressures are a serious concern for the Fed not only because commodity prices have hit record levels, but the US dollar is also weakening. Oil has been emblematic of the bull market in commodities, hitting a record $100 a barrel on January 2nd. In response, gold in turn hit a record high just shy of $870 per ounce. High energy prices have also driven basic food commodities such as wheat and soy beans to new contract highs. In mid-November wheat touched a record $10.00 a bushel. The full impact of escalating commodity prices still have not been fully realized nor does the uptrend appear to be over. On January 3rd, the usually circumspect Nabuo Tanaka, Executive Director of the International Energy Agency released a report projecting energy supply and demand pricing for 2008. Based on Asia's burgeoning demand propelled primarily by China and India, his agency said it would not be surprised to oil at $150 a barrel.

Do not expect US officials to stand in the way of further dollar weakness. With rising commodity prices, the US economy needs a weaker dollar. Not only does that increase foreign demand for US goods, but it can also spur renewed foreign investment. There are three different ways that foreign investment can help buffer any slowdown in the US economy and the US dollar. Over the past few years, foreigners have been big buyers of US real estate. According to a study by the National Association of Realtors, about one in five American real estate agents sold a second home in the year ending April 2007 to a foreign buyer. A third of these buyers come from Europe, a quarter from Asia and 16 percent from Latin America. As the US dollar continues to fall in lockstep with house prices, foreign buyers could provide the support that the US housing market needs to avoid a major crash. The second support could come from the US equity markets.

If the dollar continues to fall, foreign investors may begin to acquire companies with sound fundamentals that are also less vulnerable to a US economic slowdown. Both of these factors are contingent upon the US dollar showing signs of stabilization. Foreign investors will only swoop in with size when they believe that dollar weakness is nearing an end. The third factor is less contingent upon the outlook for the US dollar which is that a weaker dollar also makes US corporations more attractive buyout targets. Sovereign wealth funds of countries like China and Dubai are flush with cash and they are on the lookout for good investment opportunities. These funds already have demonstrated their hunger for U.S. assets.

As the first quarter opens, there are more questions about the dollar's continued value than answers. If commodity prices continue their uptrend, then clearly asset-based currencies like the Canadian will benefit. If the Japanese economy continues to demonstrate its solid fundamentals, then it too reach higher against the dollar. Both the politics and economy of the Eurozone are less certain. Higher commodity prices will put a damper on growth in Europe. Politically, however, the European Central Bank under the leadership of Jean Claude Trichet has shown a willingness to let the Euro inflate without intervention.

The bank's inaction may be as much about vanity as it is about the numbers. Europeans dream about a day when their currency will be on an equal footing with the U.S. Dollar. This political goal alone, may be enough to push the Euro to new heights above the 150 threshold versus the dollar. Given this understanding, I recommend staying long on the Euro, Canadian and Yen. I would look for oil and commodity prices to continue their uptrends, and would not be at all surprised to see gold pierce $1000. At all points, be wary of intermediate profit taking. Book your profits early, cap your losses on corrections, and don't be afraid to embrace the risk by buying into market weakness. As the legendary financier Baron Rothchild was fond of saying, "Buy when there's blood in the streets." Hold on ... 2008 is going to be a wild ride!

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