After a string of relatively strong economic reports, as well as an FOMC statement signalling a “pause” in rate cuts, the dollar is rallying–up 4% since slumping to an all time low in April. But this modest gain only hints at the stronger recovery to come, says Credit Suisse. CS predicts that the dollar will rally to $1.45 against the Euro within six to twelve months and gives five reasons why.
First, the dollar is cheap:
The dollar is very cheap. We can see this on PPP [purchasing power parity] against both the Euro and sterling. Sterling is trading 27% expensive on PPP (close to a post-war high) and the Euro is trading 33% expensive on PPP- compared to a peak of 38% overvaluation in 1975, 1979 and 1992… the dollar trade-weighted is still very close to its all-time low and dollar cycles tend to last 7 years and we are in the 7th year of dollar bear market.
Second, the current account deficit is narrowing:
The US current account deficit is sharply improving. Not only is it 5% of GDP (down from a peak of 7%) but excluding oil it is almost 3% of GDP. Moreover, ISM export data relative to import data suggest this surge should continue (with ISM exports at an all-time high against imports).
Third, interest rate differentials will become more favourable:
Interest rate differentials from here should close. Near-term, we can see that the Euro/dollar has been moved by interest rate differentials. From here, European and UK rates are likely to fall more than US rates, especially when we consider LIBOR. A year out UK LIBOR is discounting rates of 4.9% -we think 4.00% is entirely possible and a year out EURIBOR is discounting rates of 4.1%- we think 3.5% is possible. Meanwhile a year out, the Eurodollar futures is discounting rates of 3.1%.
Fourth, Europe will begin to struggle just as the U.S. begins its recovery:
Growth differentials narrowing. The best lead indicators in the US show some form of modest stabilisation (both ISM new orders and non-manufacturing ISM new orders were flat last month), meanwhile the best lead indicators in Europe are heading down (IFO expectations and CBI expected orders, see slide 10). With the tax rebates feeding through now it is probable that we will continue to get a relative bounce in US growth. Do recall that European monetary conditions today are consistent with sub-1% GDP growth in 9 months’ time.
Fifth, US investors are already sufficiently geographically diversified, and are unlikely to spend much more money buying up foreign assets:
The US has already diversified into overseas assets as US investors now hold almost 20% of mutual fund assets overseas compared to 8% in 2003.
This logic makes sense. In the short term, the greenback will likely be range-bound between ~ 1.58 and ~1.50 as traders try to get a fix on whether there will be one more rate cut or not. But after this period of uncertainty, expect to see the dollar take off as Europe and Japan struggle and the US begins the slow road to recovery.
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