After several attempts for the USD to break higher, over the last couple of weeks, it is about time to re focus our feelings towards… … it. In this report we will outline what we think will be the main drivers concerning a potential “about face” in the recent USD bull trend and introduce a few ideas that when combined suggests that the USD is about to weaken across the board. Our summary includes a few trade ideas in order to capture the move and also an exit strategy should our analysis be incorrect. So what do we feel will be the main drivers behind the USD weakening?

Just recently in our Report “Will China’s demand for Oil continue unabated?” we looked at export demand growth for goods from China to the US slowing and given the current environment, expect growth will be tempered for a while. In this report, we suggested that US GDP growth was suffering as a consequence of high in put prices, consumer sentiment was softening, durable goods orders and savings rates contracting ie savings to their lowest levels since 1933; all this within an environment that is seeing interest rate continuing to edge higher. However, the USD has remained remarkably bid since this analysis; nevertheless we believe a reappraisal of the USD’s fortune is imminent. A rethink by investors on investments in US Government and Corporate Bonds and a re think by the Federal Reserve on the concerns associated with the burgeoning trade gap.

The yield gap between the US and the rest of the world has been a focal point for sometime. Investing in the USD is a high yielding play against most currencies. The relatively high US yield on Bonds has attracted funds from investors domiciled off the US shores, namely Asian Central Banks and Asian high net worth individuals. As it stands these investors currently own about half the US treasuries outstanding, this is up from 35% in 2002. The Federal Reserves mantra has been to try to balance the effects of sustaining economic growth whilst making sure that investment in Bonds, to finance the deficit, remains strong. To date it has been doing a remarkable job. However, with raw inputs prices remaining high and US interest rates expected to reach 5.25% by September, we should expect to see economic growth slow down. Fresh US Retail Sales figures, down 1.3 % last month and other leading economic indicators are shifting focus towards the prospects of a slow down. So it is questionable as to whether or not interest rates will continue their march north. However, at the same time global yields are also increasing and international investors will be placed with the decision to either continue to invest in US debt and an economy that potentially slows down or their own domestic economies that are firmly placed to gain.

Recent data from the US suggests that this trend away from the US is gaining momentum. Foreign investment in US Bonds has dropped from USD 18.3 billion in December to USD 4.4 billion last month and Corporate Bond investments have slowed from 32.7 billion in December to 23.5 billion in January. Lack of support from the international investor for both Government and domestic corporate Bonds could potentially cause funding issues for the Federal Reserve and Corporate America. The Federal Reserve needs to make sure yields are high in order to attract investors to fund the deficit. However, USD Capital flows in January failed to cover the deficit for the second month in a row, revealing, perhaps a “chink” in the Feds’ mantra and an alarming trend that would need to be addressed as soon as possible. In addition, given comments by the Feds’ Bernanke concerning this and the impact of the Trade Deficit we suspect we have hit a tolerance level.

The US Trade Deficit continued to show the gap widening in the Fourth Quarter by US224.9 billion and with the record 2005 Deficit last year of US726 billion the US deficit is on track for another record breaking run. Bernanke is concerned that “as net external debt rises, the cost of servicing this debt subtracts from US income’. Accordingly he mentioned that it would be good if “domestic saving increased or there was a reduction in the trade deficit”.

Taking a brief look at these two “asks” we see that it could be a tall order. Firstly, given that the trend for domestic savings is at its lowest level since 1933 we are talking about a shift in consumer sentiment ie away from its traditional hedonistic ways to a more conservative society, a consumer focused around saving. The chart below shows the Personal Savings rate since 1959. As can be seen it has been trending down for sometime and a shift in sentiment from 0.0% will be hard unless provoked.

US Disposable Income Savings Rate 1959 – 2005

(Bloomberg)

A shift towards savings is required (by the US Consumer) to slow the growth of imports and address the trade imbalance. US companies and consumers are benefiting from the booming Chinese and Indian economies providing both cheap labour and products. However, it has come at the expense of a record current account deficit and increasing protectionist sentiment from Capitol Hill. The US has become complacent and the production cycle for many consumerables in the US now incorporate Chinese and Indian inputs that would be hard to duplicate back in the US. The US trade deficit will continue to suffer.

So, given that these “asks” by Bernanke may be hard to deliver; what is it that will cause the most concern for the Federal Reserve: a strong Dollar that encourages imports or merchandise from abroad and discourages capital inflow. Hence Bernanke comments of late on the savings rate and trade deficit suggesting that the market has reached a tolerance level and with out saying it the need to preach a weakening USD.

How do we take advantage of our current view of USD weakness? We believe that the GBP and the JPY are perhaps the best currencies to look at to purchase against the USD as we are close to the lower end of the range for the GBP/USD and higher end for the USD/JPY. A break above 1.7520 on a daily close for the GBP/USD and a break below 117.15 on a daily close for the USD/JPY should see the commencement of the trend. Like wise we are wrong for the time being if 1.7200 and 119.50 breaks (see charts below).

If these breaks occur then we will look for 1.8000 on the GBP/USD and 112.00 on the USD/JPY.

Jonathan Barratt BEc| Head of FX and Metals | Tricom FX & Metals
Ph +61 2 8274 6121
Ph 1300 732 288
Fax +61 2 9251 6331
jonathan.barratt@tricom.com.au
http://www.tricom.com.au/