Thursday, May 19, 2005

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Contradictory signals on the dollar

Two reports today send conflicting signals about what's going to happen to the dollar in the near term.

In the Chicago Tribune, Bill Barnhart reports that one longstanding bear thinks Bretton Woods 2 is going to last a while:

The good news was compounded by a bullish commentary by legendary bond-market bear Bill Gross, chief investment officer of Pimco.

In remarks released Wednesday, Gross, who has been well known for years for his gloomy predictions about interest rates, said a political bargain between officials of the United States and Asian nations, notably China, should keep U.S. inflation and interest rates low for several more years....

In his commentary, available at, Gross said the 10-year yield could drop to 3 percent within five years.

Professional bond traders are overwhelmingly bearish on interest rates, expecting the 10-year yield to climb this year toward 5 percent.

But Gross argued that a political bargain between U.S. and Asian officials means "a range of 3 percent to 4.5 percent for 10-year nominal Treasuries will prevail."

Gross said U.S. and Asian nations seem to have entered a political pact, whereby Americans can consume cheap imported goods and afford houses, while Asians can protect their economies, create jobs and maintain competitive currency values.

The refusal of the Bush administration on Tuesday to label China as a currency manipulator for pegging its currency to the dollar contributes to the "bargain" theory.

"America's growth has been stitched together more from the iron fist of government policies than the invisible hand of a dynamic free enterprise economy," Gross wrote.

In his January commentary, Gross had predicted that China would revalue its currency higher in 2005, a move that likely would send the U.S. dollar lower and U.S. inflation and interest rates higher. At that time, he urged investors to hold assets in cash.

On the other hand, Anna Fifield and Chris Giles report in the Financial Times that South Korea is about to roil these waters:

South Korea's central bank will not intervene any further in foreign exchange markets, the governor of the Bank of Korea said on Wednesday in comments likely to unsettle financial markets.

“I believe that we now have sufficient reserves to secure our sovereign credibility, so I do not anticipate increasing the amount of foreign reserves further,” Park Seung told the Financial Times. South Korea's foreign currency reserves stand at $206bn the fourth largest in the world.

Mr Park said: “We now need to take more consideration of profitability, and I think we're at a stage where we need to manage our reserves in a more useful way.”

Although he made no explicit comment on the won, Mr Park's remarks imply that South Korea is now unwilling to undertake the intervention required to stem its currency's rise....

With Japan, China and South Korea which together hold at least a third of the world's central bank foreign exchange reserves each likely to suffer if one moves first to lessen their exposure to the dollar, some economists believe there is scope for more regional co-operation.

Mr Park said: “I think that the economic co-operation of these three nations and the co-operation of their central banks is necessary to promote the growth and development of the global economy.”

But the banks were working together only to maintain financial stability and were not doing anything that might “affect” international markets, he said.

Click here to see what happened the last time South Korea said anything about its dollar purchases.


UPDATE: Brad Setser links to a Financial Times follow-up by Anna Fifield on the Bank of Korea decision, in which the Bank walked back furiously from Park's comments:

The Bank of Korea on Thursday backtracked on its comments that it did not plan to intervene further in the foreign exchange markets, after precipitating a sharp fall in the US dollar overnight.

Currency traders said it appeared that the central bank in fact bought dollar-denominated assets on Thursday morning, less than 24 hours after Park Seung, the governor, told the Financial Times that he did not “anticipate” doing so....

Mr Park’s comments pushed the won up sharply against the dollar in US trading on Wednesday, and it hit 999.5 immediately after the local market opened on Thursday but shortly fell back below the psychologically-important 1,000 mark to close at 1,005.

The central bank on Thursday confirmed that Mr Park had been quoted accurately but it nevertheless released a statement saying that he had been “misunderstood.”

“The Bank of Korea will take necessary measures whenever the currency markets are unstable. Especially, we will not sit idly by if speculative funds come in to exploit a groundless news report,” it said....

Even Han Duck-soo, finance minister, last month said that reserves of about $200bn “may be adequate” for South Korea. But on Thursday Mr Han said Korean authorities would continue taking action when the foreign exchange market showed any instability.

“When we see speculative forces and excessive volatility, we will act together with the Bank of Korea through smoothing operations,” he told reporters on the sidelines of a conference in Seoul.

Here's a link to the original FT interview with Park.

As Setser points out:

It sure seems like the Bank of Korea (the central bank) and the Ministry of Finance (if not the entire government) are in somewhat different places. The Finance Ministry is worried about any slowdown in growth, and Korea's export growth seems to be slowing. This policy dispute just played out in a very public way.

I concur -- there's no way, especially after the February episode, that Park didn't know what the effect of his interview would be on the currency markets.

posted by Dan on 05.19.05 at 11:13 AM


the koreans backpedalled like mad today -- see the FT. tho i do think that at least the central bank is rather tired of adding to its treasury portfolio.

posted by: brad on 05.19.05 at 11:13 AM [permalink]

Correllation is not coordination. It's true that Asian countries desire to maximize exports to the American market influences their central banks' purchases of dollars, but they did not need American assistance or encouragement for this. Fear of what sudden change might do to their exports and to the rest of their economies is a factor now for them, as it is for us, but that too is more a result of similar perceptions of the fundamentals than it is of coordination between the governments. The South Koreans more than the Chinese seem to be having some doubts about those fundamentals.

The difference is that China, South Korea and other Asian governments are pursuing a deliberate policy to grow their respective economies in a certain way. The Bush administration has merely been trying to keep the economy humming along well enough to get itself through the 2004 election, and now to prevent a renewal of high interest rates, inflation or both. The effect is to place the power of decision over the future of the American economy more and more in foreign hands.

posted by: Zathras on 05.19.05 at 11:13 AM [permalink]

"Gross said U.S. and Asian nations seem to have entered a political pact, whereby Americans can consume cheap imported goods and afford houses, while Asians can protect their economies, create jobs and maintain competitive currency values."

I didn't think he said this. I thought half the article was about how asset prices have been going up because Greenspan engineered 5 year Treasuries higher. And that now the 5 year has reached the 0% real return barrier. So the asset increases are probable gone.

I thought his essay had a lot of facts which are probable correct, but no actionable information. Or I guess you need to know more than I do to be able to take some type of action.

posted by: Chad on 05.19.05 at 11:13 AM [permalink]

that's a gross misinterpretation of gross, if i may say. if anyone has eyes to read tho, he explicitly states:

"This bullish scenario is not without its risks, be they geopolitical, trade, oil, or internal budget popping related in the U.S. or Euroland. In addition, anything that threatens BWII or resembles a 'helicopter money' monetary response described by Ben Bernanke could ultimately be bond market destructive."

while gross' bond bullish scenario is predicated on BW2, it is not an endorsement of its stability. in fact earlier in the piece he says that BW2 is inherently in an unstable equilibrium. rather, it's his belief in the limitations of the fed's "asset pump" that's why he thinks rates can move lower, a wholly different concept that he explains in the second half of his article, which again weakly assumes as given the persistence of BW2. his verdict? the US is an emperor whose clothes are stitched out of threads that "have been secured on the back of rapidly increasing debt, resulting in a 6% of GDP balance of trade deficit, and that debt has been extended to consumers only because of asset appreciation in the financial and housing markets."


It isn't prudent for U.S. citizens to continue to expect to consume 6% more than they produce, nor is it rational for investors to expect foreign central banks – primarily the Chinese and Japanese – to invest that 6% surplus and other direct investment monies into the U.S. Treasury market forever. At some point it comes undone, either through a massive revaluation and dollar decline, a Treasury buyer's boycott, or a whimpering U.S. consumer beaten down by the cost and/or amount of their burgeoning leverage – much of which is housing related. Geopolitical risks abound as well with North Korea, Taiwan, and Iran serving as potential flash points. Since the Bretton Woods II arrangement currently seems to satisfy giver and taker, consumer and maker, it should survive for a few years. Cross those fingers, though.
so where in there does gross think "Bretton Woods 2 is going to last a while?"

posted by: carabinieri on 05.19.05 at 11:13 AM [permalink]

To some of us "a few years" is a while.

And given that gross was arguing in dec/ jan to steer clear of longer terms bonds, his embrace of duration and his 4.5 to 3.0 call (if BW2 lasts) was a bit of a shift. It is, as you note, premised on the assumption that interest rates cannot fall all that much lower, and thus the "Asset pump" is on its last legs since the long-term decline in interest rates (rise in asset prices) can only go a bit further, limiting inflationary pressure ...

Dan -- seems like my readers are a bit more about korea's reserves than yours. on the other hand, i sometimes have trouble ginning up comparable interest in geopolitical issues ... non-overlapping audiences, apart from Godement, i suspect.

posted by: brad on 05.19.05 at 11:13 AM [permalink]

again, "is going to last a while" is different from 'should last a few years with fingers crossed'. i think he presents a more nuanced argument than you (and certainly barnhart) give him credit for. and recall, he was synthesizing the findings of the secular forum and not necessarily providing his own view, altho i would not begrudge a bond guru a shift (an evolution if you will) over several months as new data accumulates, even if it happens to be a 10-year note yield pushing 4%... how else to explain the conundrum? i thought he/they did an adequate if not admirable job; more 'honest' than anything the fed has provided lately, in any event, i think. it's nice having a 'shadow' fed around for a reality check, or at least a second opinion.

posted by: carabinieri on 05.19.05 at 11:13 AM [permalink]

After following the dollar daily for the past few weeks, I resorted to my old economics text book by Gwartney et al. Just re-reading the fundamentals of foreign currency and sitting back and pondering the news has made more sense than trying to wade through the swamp of experts.

posted by: Ray on 05.19.05 at 11:13 AM [permalink]

All these comments and Daniel's own commentary I think miss the point. Sure, the US policy towards the dollar is a fun political football to toss (or kick) about. But if you really care what direction the dollar will go from here you have to look at the big picuture. In particular you have to ask whether the dollar is low or high relative to its historical range. Moroever, you have to ask where most people expect the dollar to go from here. Compare to its range of the past 30 years of 78 to 164, the dollar index today at 86 is low. And everyone I read, especially the New York Times, thinks the dollar has to go down over the next couple of years. I think you can safely assume that the dollar index will not drop below the 80 level it reached on December 31, 2004 and will move up above 100 over the next couple of years.

posted by: Carl Futia on 05.19.05 at 11:13 AM [permalink]

Carl -- depends a bit on what you want to look at. I know lots of folks on the street follow the dollar index closely. I don't fully understand why -- it is a composite of the euro, pound, yen, canadian dollar, swiss franc and swedish kroner (with maybe some aussie $ thrown in). As a proxy for the "dollar"s external value, it increasingly looks dated. No mexican peso, brazilian real, indian rupee, korean won, taiwanese dollar or chinese RMB. It it is relevant if you want to hedge certain types of exposure, but as a indicator of broad $ strength, it doesn't work. it is in an indicator of $ strength/ weakness v. certain advanced, formerly industrialized economies ... (china = industrialized economy right now, but it lacks a convertible currency).

I don't have complete certainty about the dollar's direction on the dollar index or any other index -- i certainly would not have bet on the strength of the current $/ euro rally. But if the dollar stays at its current level, i am confident that -- with normal growth in the us and the rest of the world -- the trade deficit will tend to widen. you either that is fine, and poses no problems, since the financing will be there -- in which cases, there is no short-term obstacle to a sustained $ rally over the next couple of years. I tend to think that view is off -- and the markets will react to a 6% of GDP heading to 7% of GDP trade deficit (and a larger current account deficit), and thus the dollar will tend to depreciate from current levels over time across a broad range of currencies. To me, it is hard to bet on a sutained appreciation of the currency of any economy with as large a set of deficits as the us.

posted by: brad on 05.19.05 at 11:13 AM [permalink]


posted by: Jim Dandy on 05.19.05 at 11:13 AM [permalink]

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