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54anickel Donating Member (1000+ posts) Send PM | Profile | Ignore Thu Feb-03-05 07:54 AM
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16. Falling Spreads Bear Dollar Reality


Confirm payroll creation above the 150-70K over a 2-3 month range and a PCE core price figure above 1.6% would raise chances of the Feds dropping the measured directive and pave the way for more aggressive tightening. Until then, the Fed has no reason hastily step up its pace of tightening, especially at a time when the record trade deficits drag on GDP is at its largest in 7 years.

Rate Hikes, Yield Curve and the Dollar

We have already established in previous notes that interest rate hikes could not alone be the driver of the dollar. The 300-bps tightening from February 1994 to June 1995 led to a 5.1% drop in the dollars trade weighted average mainly because of the Clintons administration quasi-trade war with Japan. The Clinton Administration espoused a policy of benign neglect similar to the current one. When then Treasury Secretary Lloyd Bentsen was asked whether he preferred a weak a dollar he replied he wanted: a strong yen. Times are similar today. The Feds is rate hikes are doing little for the dollar because the White House is sticking with is benign neglect for the dollar. Though more discreet than Sec Bentsen, Snow and company are pushing for a de-facto weakening of the dollar by urging for a revaluation of Asian currencies (which would drag the dollar against the currencies of emerging Asia).

Yield differentials between 2 and 10 year treasuries are also worthy of consideration for currency traders. The past 6 rate hikes have lifted 2-year yields to a 3-year high of 3.32%, while maintaining 10-year yields near their 2-year daily average of 4.14%. The 2-year notes daily average over the same period stands at 2.04%, well below its current rate of 3.32%. This has resulted into an 18-month decline in the spread between the two yields (10 year 2 year) reaching 0.8%, the lowest since May 2001. The chart below shows dollar to fall under pressure during periods of tightening spreads and generally low interest rates. Unlike a falling yield spread where both rates are rising or falling closely together, todays falling spread between long and short term rates is caused by directionless long yields (courtesy of Asian purchases of US treasuries, benign inflation outlook and possibly benign growth outlook) and rising short yields (courtesy of the Feds tightening which is a normalization of monetary policy).

Indeed, the last bear market in the dollar was in 1994-1995 when falling spreads and low long-term yields prevailed. As long as long yields shun the Feds tightening, the message of the market remains the following: Feds current tightening aims at normalizing monetary policy instead of containing an overheating economy, in which case currency markets give no growth reward to the dollar.

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