USD: SHORT TERM GAIN, LONG TERM PAIN?
The rally in the U.S. dollar during the North American trading session can be interpreted as a vote of confidence for President Obama’s tax cut deal. It is no secret that the dollar has a very strong relationship with U.S. bond yields and this helps to explain why the greenback managed to extend its recovery against the major currencies. U.S. 10 year bond yields saw its biggest increase since 2009, settling at 3.14 percent, a 6 month high. The rise in bond yields confirms that investors have faith in Obama’s ambitious plan to stimulate the U.S. economy. The only question is whether the rise in dollar is a short term gain that could lead to some long term pain. In order to pay for the extended tax cuts, unemployment benefits and one year reduction in Social Security taxes, the U.S. government will be adding to the national debt, which is already at a record high. From a credit worthiness perspective, assuming more debt means a weaker fiscal position that should make the dollar less attractive to foreign investors. Yet the dollar has rallied because investors believe that the tax cut could revive the U.S. economy and pave the way to more normal monetary policy. President Obama’s Gamble
In other words, President Obama is betting that the tax cuts will spur enough growth to make investors forget about the additional debt required to pay for it. At this fragile point in the U.S. recovery, we believe that Obama is correct in saying that a sudden increase in taxes would be crippling for the U.S. economy. It is not a stretch to predict that the tax cuts will protect the U.S. economy against a deeper slowdown because allowing the tax cuts to expire would basically be akin to reducing stimulus - which America cannot handle at this time. Yet the more important question is whether the cuts will be enough to engineer a recovery that is felt down to the lowest parts of the U.S. economy. In order to have a good chance of reviving the U.S. recovery, Obama announced more stimulus than most economists had anticipated. In addition to extending unemployment benefits and the Bush tax cuts, he also announced plans to reduce payrolls taxes. In total, this should add approximately $185 billion in stimulus and boost GDP growth by approximately 0.75 percentage points in 2011. Tax cuts are a better way of stimulating the economy than Quantitative Easing, which is not really an option at this point given the political backlash against QE2. The tax cuts should boost consumer spending next year and hopefully lead to some upside surprises in U.S. data that evolves into a fundamental shift in the outlook for the U.S. economy. This is the gamble that Obama is taking and if he is right, then the dollar’s rally can be sustained but if he is wrong, then the U.S. will be left with only a massive debt burden that will scare off foreign investors. We won’t see the initial results of the tax cuts until the end of the first quarter at the earliest so in the meantime, all investors have left with is the hope that Obama’s plan will work. For the time being, the U.S. is not at risk of a credit downgrade according to rating agency Moody’s despite the near $1 trillion addition in debt and this may be enough to reassure international investors.
The euro weakened against the U.S. dollar despite what is expected to be a successful passage of Ireland’s 2011 budget. The budget that was unveiled today included the toughest belt tightening in the country’s history, with 6 billion in projected spending cuts and tax hikes. The Parliament has approved the first line items up for vote and the plan survived with an 82-77 vote. The margin was slim but Prime Minister Cowen gets to keep his job for the time being. Unfortunately part of the reason why the euro failed to rally despite this news is because the process is far from over. Over the next few months, the budget will face more parliamentary tests with separate votes scheduled for major bills on items such as welfare cuts and the income tax net expansion. The final vote which would put the taxation items into law may not be until February. With one vote down and three more votes to go, a full resolution to Ireland’s woes is far from over. Any hiccups along the way could bring more pain to the euro. Also don’t forget about contagion risks for countries like Spain and Portugal – the threat is alive and will eventually come back to haunt the region. It also didn’t help that German economic data surprised to the downside. German factory orders rose 1.6 percent in October which represented a rebound from the previous month, but the pickup in demand was smaller than economists had anticipated. Nonetheless, it is important to note that despite the troubles in countries like Ireland and Portugal, the two largest economies within the Eurozone (Germany and France) is still performing relatively well. Manufacturing activity in Germany hit a 3 month high last month, prompting the Bundesbank to raise its 2010 growth forecast to 3.6 percent, the fastest pace of growth since 1992. We expect tomorrow’s German trade, current account and industrial production numbers to show the same strength. The bifurcated economic recovery is not to be forgotten because when the sovereign debt crisis fades from our memories, the focus will quickly return to growth. Meanwhile the seasonally adjusted unemployment rate in Switzerland held at a 1.5 year low of 3.6 percent in November, to the envy of many countries around the world.
The British pound was the only major currency to outperform the U.S. dollar. Sterling’s remarkable strength can be credited to better than expected economic reports. Even though industrial production fell 0.2 percent in October, manufacturing production rose 0.6 percent, which was the strongest pace of growth since March. The reason why manufacturing production rose and industrial production fell is because of the volatility in mining, quarrying and utility activity. Output increased in 10 out of the 13 sectors tracked by the manufacturing production report. The British Retail Consortium’s Retail Sales monitor also showed signs of stronger consumer spending. According to the report, retail sales rose 2.8 percent in November. The Bank of England is gearing up for a rate hike this week and even though they are not expected to make new any comments related to the economy or monetary policy, the recent improvements in economic data will give them peace of mind.
by: FX360
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