The US$ could only defy gravity for so long. The veneer of complacency started to peel away on the eve of the U.S. Thanksgiving holiday, coinciding with the White House cutting its U.S. growth forecasts for 2006 and 2007. The downside risks to the US$ were laid bare, and the headwinds that have been apparent for some time became more forceful. Those factors include the outlook for slower U.S. growth compared to forecasts of a still-solid expansion in Europe, and the fact that policy rate spreads will narrow further as the Fed is expected to cut rates in 2007, while the ECB and other European central banks maintain tightening biases. Before this drama unfolded, market volatility had been dying a slow death. Currencies were trading in increasingly narrow ranges, getting wound tighter and tighter and tighter. Eventually, something was going to snap. It has, and the task for December and the first half of 2007 might be trying to keep track of the unravelling.

The FX market has already almost fully unwound the 2005 US$ rally that was driven by Fed rate hikes and U.S. corporate profit repatriation. The Federal Reserve’s trade-weighted exchange rate versus the major currencies looks set for an excursion below 80. This would retest levels last seen in December 2004, and before that, at the dawn of the strong dollar policy in May 1995 when then U.S. Treasury Secretary Rubin said that “this Administration believes a strong dollar is in America's interest.” Accordingly, other currencies are stronger than they have been in a decade or longer. The Canadian dollar hit its highest levels since 1977 in May, before retreating. The British pound has revisited levels unseen since it abandoned the ERM in September 1992. Meanwhile, neither the euro nor the Japanese yen are very close to their 1995 peaks, although currency strength would boost consumer purchasing power and aid the needed transition from export-led to domestic demand-led growth. The euro remains about 10% below the peaks for the legacy currencies, such as the deutschemark and the French franc. Meanwhile, the yen would have to strengthen to firmly below 100, which it won’t likely do for some time.

An ongoing, orderly US$ decline is a key factor in correcting global imbalances. However, the burden must be shared. Hence, there will be increasing focus on the weakness in the yen in coming months as it could act as a headwind to Asian currency strengthening, which is a crucial element in the adjustment process. Meanwhile, the G7 still thinks “disorderly movements in exchange rates are undesirable for economic growth.”

U.S. Dollar

The US$ seemed to suddenly become sensitive to the prospect of a U.S. economic slowdown, and Fed rate cuts in 2007, while several other central banks remain on tightening paths. The market has become increasingly convinced that the Fed will cut rates in 2007, even though Federal Reserve officials continue to fret over core inflation readings, such as the core PCE deflator stuck at 2.4% y/y, that remain frustratingly above their “comfort zone.” However, the slowdown in the housing market continues, with ongoing price declines and the prospect of residential construction job losses weighing on consumer sentiment. The slower growth scenario is reinforced by the good, but not spectacular, start to the holiday shopping season and signs that the very mature U.S. factory sector expansion is cooling after 42 months, the longest period without a pause since the late 1970s. The more interesting debate now is whether the U.S. housing slowdown is “a necessary cyclical correction in the U.S. economy,” a view expressed by Bank of Canada Governor David Dodge, or a more fundamental development that could weigh on U.S. consumer wealth and consumption. There are other factors at play in the US$ situation. Asian central banks are continuing to diversify away from the US$, paying heed to the Asian Development Bank’s March warning about the possibility of a rapid fall in the U.S. dollar. The risk of a sharp decline in the US$, while considered small, has been discussed regularly by the IMF, most recently in September’s World Economic Outlook. An orderly decline in the US$ is widely anticipated, although not wildly popular.    

Canadian Dollar

The C$ is underperforming the greenback, even as the US$ has gone into retreat. Accordingly, the loonie has experienced sharp declines against many cross rates, particularly the European currency bloc. The late-2005 petro-currency C$ rally has been all but reversed. Although recent moves have been fast and violent, the Canadian dollar looks set to continue to weaken on the cross rates, and against the US$, depending, as always, on the performance of commodity prices. There is a chance of a short-covering rally, as speculative net C$ short positions on the IMM are at record levels, but the underlying trend continues to suggest further unwinding of last year’s rally. Bank of Canada Governor Dodge, while in Australia, noted his concern with the U.S. housing-led economic slowdown, “which for us in Canada because we supply an awful lot of bits to the US housing industry, is not good news.” Domestic demand remains firm, but net exports are a sufficient headwind that the Bank of Canada remains poised to cut rates in the first half of 2007. Canadian consumers should thus get a double-barrelled dose of stimulus in the spring, as Finance Minister Flaherty is preparing a tax-cut heavy budget. Opportune? Yes, but also necessary to help continue the reorientation of the Canadian economy to reflect the new reality of commodity markets.

Europe

As the U.S. economic outlook has dimmed, data from Europe have shown a resiliency suggesting that growth in 2007 will remain healthy, helping support the recent euro rally. This has caused French political leaders to fret about the strength of the euro. Other EU officials might not be as concerned at the present time, but they are concerned that Europe will carry the bulk of the burden of adjustment of the U.S. current account deficit, something that they do not see as their problem. However, the Eurozone still has a large trade surplus with the U.S. that has to narrow over time, in part by slower import growth in the U.S., along with faster domestic demand growth in the Eurozone. This is unfolding in an environment of still ample Eurozone liquidity, and with the ECB still in the early stages of restoring balance. This implies that European interest rates are going to remain under upward pressure through 2007, as will the euro. But rate hikes will be gradual and spread out over the next two years, or so, in order to not derail the transition from export-led to domestic demand-led growth. It’s tricky, but crucial to the future health of the global economy. The ECB is not the only European central bank leaning toward rate hikes. Sweden, Norway, and Switzerland have openly conceded that higher rates are in the offing. Even in the U.K., the Bank of England has not closed the door on a follow-up to November’s rate hike.

Asia

What’s with the yen? Not long ago when “Asian currency problems” were discussed the topic was the Chinese yuan. No longer. Now it is the yen that is stymieing Asian currency adjustment. The ADB has called for East Asian nations to “allow appreciation collectively,” to share the burden of the global adjustment of current account imbalances, and to slow the growth of FX reserves. This would also preserve regional competitiveness, which remains a great concern for countries that still need to create jobs quickly enough to alleviate poverty. The yen is presently putting a choke-hold on this adjustment process. This is occurring even as it seems that China is becoming increasingly comfortable with a stronger yuan. This is not a surprise for several reasons. First, China’s foreign reserves have topped US$1 trillion, and continue to expand at about US$220 billion per year. That is, China’s stockpile increases by an amount comparable to South Korea’s total FX reserves, which are the fifth biggest in the world. Second, China’s trade surplus for October was spectacular, a record US$23.8 billion, suggesting the appreciation of the yuan since July 2005 has not adversely affected China’s trade situation. Third, the Chinese are quite serious about helping Hank Paulson have a successful term as U.S. Treasury Secretary, and to keep the “Lou Dobbs Democrats” in line. And, with Paulson and Fed Chairman Ben Bernanke leading a delegation to China mid-month, nothing would help smooth relations more than yuan strength.