The Sincerest Flattery

American equity investors are worried about the incoming Obama administration. The Democratic candidate’s campaign promises to raise capital gains and marginal tax rates are viewed by many as a dangerous burden for a recessionary economy.  But the President elect’s tax and fiscal plans will have little effect on the positive prospects for the US Dollar.    
In the context of the world’s economies US marginal tax rates and  fiscal policy matter far less than the comparative advantage that low US interest rates and unified governmental response to the credit crisis have given the dollar. In the first blush of the sub prime crisis last summer Mr. Bernanke was pitied by his European counterparts, whose countries and banking systems they assured the world were secure and untouched by the American contagion.

Times change. The European, British, Australian, New Zealand and Japanese central banks have endorsed the Federal Reserve economic view in the sincerest possible terms; they have cut their own rates. The US Fed Funds target rate is at 1.0%. Among the major industrial economies only the Japanese rates are lower. But the dollar’s competitors in Europe and Asia have not obtained any advantage from their higher rates; neither has the dollar gained on the yen despite its own rate bonus.

The European Central Bank refinance rate of 3.25% has been reduced 100 basis points in a month; the Bank of England has cut 200 points. The last time the ECB was dropping rates the bank governors stopped at 2.0%. That 2.0% rate lasted from June 2003 until early December 2005 and is the lowest the ECB has ever pegged its refinance rate. British rates are at 3.0%, the lowest since 1955 and the first time since the introduction of the euro in 1999 that they have been lower than the continent’s. The European and British recessions have already started and the current economic and financial situation is far more distressing than 2003.  

Why mention this history? Jean Claude Trichet and Mervyn King may have finally recognized the danger to their economies but this recognition will not translate into strength for their currencies.

The US base rate, the Fed Funds target, is, with the exception of Japan, the lowest in the industrial world. 1.0% is also its modern low and it is unlikely the Fed will reduce it much more. The 1.0% rate represents the early recognition by the US authorities of the gravity and danger of the credit crisis. This recognition has translated into strength for its currency. Traders who spent almost a full year from last August until this past July punishing the US authorities for their forthright admissions by selling the dollar have spent the past three months in sincere flattery by buying the dollar almost without pause.

The October US Non Farm Payrolls brings the American job market squarely to recessionary territory. In just one elapsed quarter the three month moving average has more than doubled from -98,000 in August to -217,000 in October. The speed and magnitude of the decline in the job market underlines the severity of the September credit contraction and its devastating impact on employment. The relatively modest monthly job losses from January through August (average -81,875) were consonant with weak economic growth but not contraction. Jobs are normally a trailing indicator but a number of secondary statistics (industrial production, retail sales, consumer sentiment, factory orders, ISM) had minor late summer improvements which did not affect payrolls.  

The extraordinary pressures on business exerted by the credit market freeze in late September and October may have temporarily converted payrolls to a leading indicator. Faced with credit restrictions business owners may have had no choice but to fire workers. They may also have used the crisis as an opportunity to release staff that they anticipated would be eliminated in the months ahead due to falling sales and revenues. Jobs may be the leading indicator of this recession.

Markets hate uncertainty. As the credit and financial crisis peaked in October the dollar skyrocketed. US financial markets were frozen and the country's economic prospects turning firmly towards recession but compared to the confusion and indecision in European capitals and the quicksand of the yen crosses the dollar was both a safe haven and a hedge against collapsing equity and commodities markets.  

 
The response of the American government to the credit crisis and the recession has been determined by Ben Bernanke, Hank Paulson and the officials of the outgoing Bush administration. Currency traders have approved their choices by voting with their portfolios for the US dollar. The world’s central bankers have endorsed the US analysis and policy response because they have imitated it. No policy or appointment of the new Obama administration is likely to change that verdict. The president elect has said his focus will be the domestic economy and his first act will be a large economic stimulus. That will not hurt, it may help, either way the dollar will stay the course.