Fed's 'Volte Face' Sends The Dollar Tumbling

¹²Fed's Volte Face Sends The Dollar Tumbling

Rarely before have a few coded words in the minutes of the US Federal Reserve caused such an upheaval in the global currency system, or such a sudden flight from the dollar.

By Ambrose Evans-Pritchard, Telegraph.co.UK | 15 July 2010

The US workforce has shrunk by one million over the past two months as discouraged jobless give up the hunt Photo: AP

The euro rocketed to a two-month high of $1.29 and sterling jumped two cents to almost $1.54 after the Fed confessed that the US economy may not recover for five or six years. Far from winding down emergency stimulus, the bank may need a fresh blast of bond purchases or 'quantitative easing'. Usually the dollar serves as a safe haven whenever the world takes fright, and there was plenty of sobering news from China and other quarters on Thursday. Not this time. The US itself has become the problem.

"The worm is turning," said David Bloom, currency chief at HSBC. "We're in a world of rotating sovereign crises. The market seems to become obsessed with one idea at a time, then violently swings towards another. People thought the euro would break-up. Now we're moving into a new phase because we're hearing alarm bells of a US double dip."

Mr Bloom said a deep change is under way in investor psychology as funds and central banks respond to the blizzard of shocking US data and again focus on the fragility of an economy where public debt is surging towards 100% of GDP, not helped by the malaise enveloping the Obama White House. "The Europeans have aired their dirty debt in public and taken some measures to address it, whilst the US has not," he said. The Fed minutes warned of "significant downside risks" and a possible slide into deflation, an admission that zero interest rates, $1.75 trillion of QE, and a fiscal deficit above 10% of GDP have so far failed to lift the economy out of a structural slump.

"The Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably," it said. The economy might not regain its "longer-run path" until 2016. "The Fed is throwing in the towel," said Gabriel Stein, of Lombard Street Research. "They are preparing to start QE again. This was predictable because the M3 broad money supply has been contracting for months."

The Fed minutes amount to a policy thunderbolt, evidence of how quickly the recovery has lost steam. Just weeks ago the Fed was mapping out withdrawal of stimulus. Goldman Sachs said it expects the euro to rise to $1.35 by the end of the year. The yen will appreciate to ¥83, through the pain barrier for most of Japan's big exporters. The new twist is that SAFE, China's $2.4 trillion fund, has begun buying record amounts of Japanese bonds, a shift in reserve allocation away from the dollar.

The signs of a deep and sudden slowdown in the US are becoming ever clearer as the "sugar rush" from the Obama fiscal stimulus wears off and the inventory boost fades. California, Illinois and other states are cutting spending, tightening US fiscal policy by 0.8% of GDP. Thursday's plunge in the Philadelphia Fed's July index of new manufacturing orders to –4.3 suggests that the economy may have buckled abruptly, as it did in mid-2008. The Economic Cycle Research Institute's ECRI Leading Indicator has tumbled, reaching -8.3% last week. This points to a sharp slowdown or recession within three months.

In fact, ECRI states:

February 2010 ECRI goes on public record about implications of upcoming slowdown (CNBC clip). March 2010 “With stronger U.S. economic data discrediting the doubters, double-dip talk has dried up. Not surprisingly, most economists are marking up their growth projections for 2010 and beyond. As usual, such prognosticators are focused largely on coincident economic indicators, which they then extrapolate. This is why there was so much fear of depression last spring, when we forecast a growth rate cycle upturn, based on our objective leading indexes. Having correctly predicted an upturn in economic growth in the face of widespread skepticism a year ago, those leading indexes are now anticipating a near-term cyclical peak in U.S. economic growth. Specifically, growth in the U.S. Long Leading Index (USLLI) has declined for five straight months to a ten-month low [[that was as of March; since then it's gotten successively worse: normxxx]]… The directional unanimity among our sector-specific leading indexes is striking. Just as compelling are the successive downturns in USLLI growth, WLI growth and USSLI growth, which are providing sequential signals of an upcoming growth rate cycle downturn for the overall economy – precisely as expected… (Thus), even as people are starting to believe that the perfect storm has ended, clouds are gathering on the horizon.” April 2010 “There is no doubt that USLLI growth is in a post-recession cyclical downturn… (O)ur forecast of a growth rate cycle downturn by mid-year remains fully intact. With the markets growing increasingly confident about a sustained acceleration in U.S. economic growth in the coming months, this highlights a potential divergence between ECRI’s outlook and growing market optimism.” May 2010 “The risk of a cyclical downturn in stock prices has risen significantly. Moreover, we are approaching the most dangerous period of the business cycle to employ a buy-on-dips strategy.” If you take a look at the chart below, you’ll see the important historical relationship between the WLI and past recessions. This clearly shows why the latest WLI reading, as well as the persistency of the decline, support an argument of a 'double-dip' recession hitting the U.S. [[Note: The NBER, the official arbiter of recessions, has still not declared the 2007-2009 recession over— so this may just be the next leg of that recession!: normxxx]] As was the case in 2007, signs of a weakening economy are not just coming from the U.S., but from all around the world, too! Leading economic indicators like the Purchasing Managers Index (PMI) are down in most major economies including Japan, the UK, France, China, Taiwan, and India. Even Germany’s PMI is stagnating! This is in spite of the euro’s remarkable decline recently, which acted like a huge stimulus to Germany’s economic growth engine — its export sector.

While US port data looked buoyant in June, the details were even then troubling. Outbound traffic from Long Beach fell from 139,000 containers in May to 116,000 in June. Shipments from Los Angeles fell from 161,000 to 155,000. This drop in exports is worsening the US trade deficit, eroding the dollar.

The US workforce has shrunk by one million over the past two months as discouraged jobless give up the hunt. [[And now are no longer collecting unemployment benefits.: normxxx]] Retail sales have fallen for the past two months. New homes sales crashed to 300,000 in May after tax credits ran out, the lowest since records began in 1963. Mortgage applications have fallen by 42% to 13-year low since April. Paul Dales at Capital Economics said the "shadow inventory" of unsold properties has risen to 7.8m. "The double dip in housing has begun," he said.

Alcoa, CSX, Intel, and JP Morgan have reported good earnings, but they mostly did so in July 2008 just before their shares collapsed. Such earnings rarely catch turning points and can be a lagging indicator. Profits have been boosted in this cycle by cost-cutting, which is self-defeating for the economy as a whole.

The minutes confirm that the Fed is split down the middle over QE. Fed watchers say the Board in Washington wants to be ready to launch another round of bond purchases if necessary, pushing the banks balance sheet from $2.4 trillion towards $5 trillion, but hawks at the regional banks are highly sceptical. A study by the San Francisco Fed said the interest rates need to be— 4.5% to stabilise the economy under the Fed's "rule of thumb". Since this is impossible, massive QE is needed to make up the difference.

Tim Congdon from International Monetary Research said the US authorities have botched policy response. "They are forcing banks to contract lending by raising their capital asset ratios. They have let M3 shrink by 1% a month, as in the early 1930s. The solution is simple. The Fed must raise the level of deposits by purchasing bonds from the non-banking system as the Bank of England has done. They refuse to do it," he said.

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Normxxx    
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