Why It’s Important To Watch The US Dollar

April 24, 2003
Edward Allen

It is important for
equity and fixed income investors to take note of current trends in
the world’s currency markets, as their investments could be affected by the
direction and velocity of a certain move. For instance, there are certain
multinational US companies such as IBM and Microsoft, that are currently
benefiting from a weaker US dollar as their goods are now “cheaper” relative to
those of their foreign counterparts.

Conversely, foreign holders of US debt and
equities are now earning lower real rates of returns, since any gains in the
prices of these instruments are offset by losses in the dollars value. This
makes US investments less attractive to foreign investors, prompting them to
sell these instruments or avoid buying them altogether; this is especially true
during periods of rapid moves in a currency, as foreign investors are given
little opportunity to hedge their currency exposure investments…

For the past few days, the dollar has been
retesting its multi-year lows against the euro and any
significant breakout above this area could have an impact on US equities
and corporate bonds. But several factors, including technicals and fundamentals
suggest that the dollar will snap back and continue to trade within a wide, dull
range against the euro.

Fundamentals

European short-term interest rate futures are
currently pricing in a 50 basis-point cut in the months ahead, whereas the US
Fed fund futures are pricing in a 50% chance of a rate cut in the Fall. This
tells us two things.

The interest rate differential, which has been
giving the euro its strength (investors seek higher relative yields) is going
to narrow in the months ahead, making higher yielding European fixed income
instruments that much less attractive.

The markets are telling us that a recovery in
the US economy is likely to happen sooner than in Europe, since they expect
the European Central bank to cut rates more than the US’.

The market’s reasoning for pricing the futures as
such is that Europe’s economy is structurally rigid with high corporate tax
rates, strict labor laws, a weak banking sector, and high unemployment. These
factors will make it harder for the European economy to improve. Conversely, the
American economy has a more flexible labor force, lower unemployment, a strong
banking sector, and a potential for $550 billion tax cut plan–all of which will
facilitate an economic recovery and encourage foreign direct investment in the
US.

Technicals

There is now a bearish divergence (bearish for
the euro) forming in the daily price charts, as the euro has been making higher
highs but the MACD indicator is making relative lower highs.