The following is an excerpt from our 26 Nov Latest Letter.
USD & Rates Outlook
In a recent piece entitled "Deteriorating Global Liquidity" by ARP of London, a section of that article included a sub section on the the liquidity driven dollar. The premise of that discussion was that of a negative correlation between the USD and global liquidity. In one of our previous Letters from Summer we wrote :
I know some are calling for the USD to now stop its upward trend, but with the backdrop of higher Fed rates, I would surmise that we still have not seen the USD uptrend ending before the Fed rate increases start to wane. I have previously said this might be by year end. Based on time, I would foresee the USD rebound 50% level reached by Q1 2006, or approx 18 months after having reached the bottom at 80, just as the Fed increases may be coming to an end.
We also wrote in another Summer Letter:
I would foresee such a timeframe as Q4 2005 or Q1 2006 -- the US 2005 budget numbers are reported in September. At that point the Fed may have accumulated enough basis-point ammo to start cutting again in Q1 2006 should weakness again raise its head.
That is to say, when the FFR (Fed interest rate) is rising, the USD is likely to be stronger. Instead of using their proprietary charts I have attempted to take this premise and map it to the existing information on hand. Here we have the 3mo. yield (proxy FFR) verses the USD index. Indeed, the premise holds up in shape as shown by the two graphs. What is interesting is the lag time between the two. When the Fed started to cut rates at the beginning of 2001 (blue vertical line), the USD continued to rise (ever so slightly) but then 12 months later started to dive southwards (pink vertical line). The Fed rate decreases continued until January 2004 from where it commenced with FFR rate increases (blue vertical line). Interestingly, the USD continued to fall for another 12 months, until January 2005. A strong causal correlation is shown, as I have often stated, regarding Fed monetary policy changes and the lag time required for "flow through" to the currency markets.
The interesting situation is now twofold. With even Warren Buffett and Bill Gates getting their fingers somewhat burned on the USD negativity, they both lost considerable amounts on shorting the USD, the situation now looks supportive of the USD over the near term. As was reported just about everywhere this last week, the FOMC minutes have indicated that they may be coming to at least consider that continued rate increases are not a given. This I had also reported upon, i.e. in order that one is seen to be actively managing the economy, but not too much, one must first raise rates in order to have something to cut again later should the FFR be too high for the economy to handle. This is what the Fed is alluding to. Maybe continued rate rises are no longer simply going to 5% and beyond as some analysts foresaw. Nevertheless, the analog situation to the above chart could be that the USD continues to rise or at least stabilize at a level above what is expected. As shown in the older charts below, my target of 92.5 has now been reached and longer term I can see a potential for USD strength to 98 which would be a 50% fibo retracement off its 120 / 80 high low respectively. We are not there yet however. No guarantees of course, but should the Fed in Q1 2006 start to pull back the FFR reigns we could see follow-on USD strength well into the Summer of 2006. This combined with a lethargic EU and as-yet-to-be-performed German reforms, we could see surprising USD strength throughout the Q1 and Q2. If the 12-month rule holds up then even despite of any Fed restraint or even cutting the FFR, the USD strength could last the entire year before 2007 turns into a repeat of 2004 for the USD (weaker & falling).
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As quoted by Sir John Templeton, who said, "The four most expensive words in the English language are 'this time it's different.'"
Well, that's it for today... for more on this article and more charts please visit the homepage www.dinl.net in the Latest Letter box.
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