Thursday, February 5, 2004
Issue Contents:
| 08:06 | Good Morning The day ahead. |
| 08:42 | Stock Survey Stock watchlist. |
| 08:49 | Daily Swing Trade: BIIB Stock setup. |
| 09:05 | Daily Swing Trade: MAY Stock setup. |
| 09:09 | Daily Swing Trade: CPWR Stock setup. |
| 09:18 | Daily Swing Trade: BRCM Stock setup. |
| 09:23 | Daily Swing Trade: EBAY Stock setup. |
| 09:25 | Daily Swing Trade: GENZ Stock setup. |
| 09:29 | Daily Swing Trade: IBM Stock setup. |
| 09:53 | Daily Swing Trade: ETR Stock setup. |
| 10:22 | Daily Swing Trade: FAST Stock setup. |
| 10:29 | Daily Swing Trade: HAL and HCA Update. |
| 10:34 | Daily Swing Trade: INTC Stock setup. |
| 11:55 | Economic Data Summary of key releases. |
| 12:07 | The Dollar Humble opinions. |
| 12:17 | The Dollar G7 in Florida. |
| 16:16 | Active Trader Transcript Real time forum log. |
There isn't too much going on in the U.S. Economic Calendar today. Most of the numbers are going to be out in less than thirty minutes.
In the headlines, it's interesting to read the following headline at WSJ.com:
Stocks are likely to rise modestly at the open Thursday, as investors return to the market following Wednesday's stampede out of tech stocks.
Excuse me, but isn't the sentence itself strange? First a stampede out and then it goes up again? I mean, you've seen the charts for a lot of these tech stocks. Most of the leaders have been going down for weeks already but I guess they need some sort of bell to make it official or something.
Yesterday, I started looking at each of the 200 or so stocks on our watchlist, and I will be continuing that today.
Stocks with potentially actionable patterns seen on daily charts will be for Daily Swing Trade subscribers, while longer-term charts will be available for Market Analysis subscribers.
First idea today is BIIB. With the lower swing high in place but no lower low below the January 29 swing low, there is still potential for this to be a pennant pattern, which is a retracement pattern in an uptrend above the 20-day EMA.
IF this is a pennant, THEN it should resolve up, and traders will have the buy alarm placed at yesterday's high of 44.39 to catch the move. The initial stop loss should be no lower than yesterday's low. The pattern is seven bars big, with two upside targets. It should be able to get to the February 2 swing high in less than two bars, and to the January 27 swing high in less than four bars.
You can see that MAY is in a similar to BIIB in that it's also a pennant that formed in an uptrend. Again, the buy alarm is placed at yesterday's high and the first upside target is the February 2 swing high, followed by the January 27 swing high as the second target.
If the setup is triggered, the initial stop loss should be placed just above yesterday's high, but it should be tighter than that if possible seeing that the potential reward is less than the potential risk at the outset.
Compuware is another pennant in an uptrend, just like BIIB and MAY. The only warning is that the ADX has been to an extreme for this symbol and timeframe, but because it's a cheapie, we know that the latecomers will be going for these, even though we perceive it to be high risk.
Again, the buy alarm is set to ring at yesterday's high, and if triggered, the initial stop loss is placed just above yesterday's low. The February 2 swing high is the first upside target, while the January 26 swing high is the second target.
NOTE: If the swing lows on any of these potential pennants are taken out on the downside, what you will then have are potential classic bull flags at the 20-day EMA, and we've seen a lot of them fail over this past week, such as JNPR and ATML.
Broadcom was a pick for the short side from Monday, and as of yesterday, it hig the second downside target of the January 23 swing low. The question now is if BRCM will slide under the 38 level on it's way to the 50-day MA below.
You may wish to monitor this one intraday and initial a swing trade intraday on the short side if it starts to crack.
This might be a Three Little Indians reversal pattern on Ebay that targets the January 12 swing low and/or the 50-day MA below if the 20-day EMA does not hold. I think it would be best to initiate a trade intraday on the short side under yesterday's low if it starts to crack.
You can see that Genzyme is doing a test of top after reaching the upside targets off a tiny classic bull flag setup. The proper way to get in on this trade on the short side woud have been to sell short on break of Tuesday's low, so we missed the boat on this one.
However, IF it should continue down toward the first downside target of the January 29 swing low/20-day EMA, we can attempt to initiate a short sale intraday below yesterday's low.
Speaking of tests of tops, IBM is where Genzyme was a day ago. Many of you will note that this is a special case, the Trader Vic 2B test of top. The sell short alarm should be placed at yesterday's low, and if triggered, I suggest a tight initial stop loss to be placed at today's high, whatever it might be at the time the short sale is executed. We would like to see it close below yesterday's low in order to take the trade home. The first downside target is the 20-day EMA below at 97ish.
NOTE: Remember that many of these trades can be done using our in-the-money options strategy.
Entergy is at an all-time high and yesterday was a one-day pullback. The way we look at it is that this is potentially the first bar of a small bull flag. We have to exhaust the buy setups first unless there is an extreme ADX reading for the symbol and timeframe. With ADX currently at 39, I would characterize this as a high-risk buy setup.
The buy alarm should be set at yesterday's high. If triggered, the initial stop loss should be placed just above yesterday's low. Since the pullback has been only one day, using our rule of thumb, it should be able to reach the overhead target of Tuesday's high of 60.20 on the same day.
Fastenal seems to have broken down from a rising wedge formed on an all-time high. It's under the 20-day MA and the 50-day MA. This is a relatively low volume trader, so it's not really someting that we want to play unless there is something compelling. What's interesting here is that this might be a small congestion before moving lower to test the downside target of the base of the wedge at the December 5, 2003 low of 45.80.
The sell short alarm is triggered on break of yesterday's inside bar, with a suggested initial stop loss at the day's high, whatever it might be at the time the short sale is triggered. It should be able to hit the first downside target of the February 2 swing low in less than two days, using the 50% rule of thumb. Otherwise, it would be moving too slowly.
Daily Swing Trade: HAL and HCA
I had Haliburton on the list as a potential Extreme ADX Reversal on the daily chart, but the trigger has gone off now, so we will look at it again tomorrow, unless you want to watch it intraday.
HCA is breaking down from a rising wedge and it was a pick in case there was continuation of the downswing already in place toward the 50-day MA below. It would have been an intraday entry anyway.
Intel failed on the bounce after breaching the lower edge of a head and shoulders reversal pattern on the daily chart. As it approaches yesterday's low, traders should be on alert in case it sets up an intraday entry here off the 10-minute charts on the short side.
We want to be there in case it's gunning for the swing low on the weekly chart, at 29.66.
Bank of England Monetary Policy Committee +0.25%
(Econoday.com) - As expected, the Bank of England's Monetary Policy Committee increased its key interest rate by 25 basis points to 4 percent. The MPC increased rates at its November 6, 2004 meeting. In its statement, the Bank said that the rate hike was needed because of above-trend growth and the continued strength of domestic demand. The Bank said that "the world economic recovery has become more broadly based. In the United Kingdom, output growth in the second half of last year was above trend and business surveys point to a further pickup in the first quarter. Household spending and borrowing have been resilient, and the housing market remains strong. Although sterling has appreciated, continued growth above trend means that inflationary pressures are likely to pick up gradually over the next couple of years. Against that background, and despite CPI inflation currently below the 2 percent target, the Committee judged that an increase of 0.25 percentage points in the repo rate to 4.0 percent was necessary to keep CPI inflation on track to meet the new target in the medium term."
European Central Bank Governing Council - Unchanged
(Econoday.com) - As expected, the European Central Bank left their key interest rate at 2 percent. The Bank had lowered its interest rate by 50 basis points to 2.0 percent at its June 5, 2003 meeting. The ECB has an inflation ceiling of 2 percent. Growth in both France and Germany managed to creep upward in the third quarter, but worries abound about its viability. The strength of the euro could nip the nascent recovery before it can gather steam. There will be a press conference after today's meeting as there usually is after monetary policy meetings.
Non-farm Productivity +2.7%
Unit Labor Costs -1.3%
(Econoday.com) - Non-farm productivity growth slowed in the fourth quarter, rising 2.7 percent vs. expectations for a rise of 3.0 percent and compared with the whopping 9.5 percent pace of the third quarter. The data reflect slower output growth and increased worker hours.
Nevertheless, productivity has grown so sharply for so long that the data do not mark an economic shift. Non-farm productivity rose 4.2 percent in 2003 compared with 4.9 percent in 2002.
The labor cost of output continues to decline, though at a less severe rate. Unit labor costs fell 1.3 percent in the quarter, much less steep than the 5.6 percent fall in the third quarter. Year-on-year labor costs were down 2.0 percent in the quarter. Compensation rose a modest 1.3 percent, down from the 3.4 percent rise of the third quarter.
Jobless Claims 356K
(Econoday.com) - In a slight back step from recent trend, initial jobless claims rose sharply in the latest week, up 17,000 to 356,000 (week ended Jan. 31). The results cloud the employment picture a bit, as falling claims had offered the best evidence of job improvement.
But the Labor Department said bad weather in the Midwest and Southeast added to the week's layoffs. And the four-week average was more encouraging, staying unchanged at 345,250 and indicating that employers are not increasing the pace of layoffs. The latest week's 356,000 total is about the median over the past three months.
Continuing claims (reported with a week's lag) were unchanged at 3.123 million. The four-week average for continuing claims, which offers an important look at how hard it is to get a job, fell to the same 3.123 million total, the lowest level in 2-1/2 years.
Chain Store Sales
(Econoday.com) - Chain stores said unusually cold weather in the Midwest and Northeast helped, not hurt, general merchandise sales in January, driving up demand for winter clothes. Stores also said sales were helped by the redemption of gift cards, a craze this holiday season. Wal-Mart posted a sharp 5.7 percent year-on-year rise in same-store sales. The nation's largest retailer said sales were strongest at the end of the month. JC Penney, a leading apparel retailer, reported a 6.4 percent rise in sales. High-end retailers again reported especially strong results, including Saks and Nieman Marcus this month.
This article is dated February 5, 2004, from the print edition. It's interesting in that after dropping since the end of 2001, we find calls that it should drop even more. Perhaps another interesting example of going to extremes after a long downtrend, based on fundamentals. We'll see where this fits in to the sentiment cycle shortly.
Let the Dollar Drop(Economist.com) - Some think the dollar has fallen too far. On the contrary, it has not fallen by enough
THE dollar is the world's dominant currency. Should the world therefore be worried by its recent plunge against other currencies? Plenty of people seem to think so. When central bank governors and finance ministers of the G7 economies meet this weekend in Boca Raton, Florida, the fate of the dollar will be high on their agenda. Since 2001 the dollar has fallen by 33% against the euro and by 15% against the Japanese yen. Currency traders around the globe will scrutinise every word from Boca Raton, looking for a signal that governments might act together to stem the dollar's decline. Many businessmen will be holding their breath as well.This is understandable. Any shift in currencies produces winners and losers. And yet the real problem facing the world economy is not a suddenly weak dollar, but a dollar which remains, even after its recent decline, too strong. The drop in the greenback was inevitable and should benefit both America and other countries, because it will help to reduce America's vast current-account deficit, which is arguably one of the biggest threats to the global recovery. For the same reason the dollar should, and almost certainly will, fall further. But some countries are not prepared to allow the dollar to fall by enough to complete the necessary adjustment to America's finances.
America's current-account deficit stands at 5% of GDP, and most economists reckon that this percentage needs to be reduced by at least half. That would stabilise the ratio of America's foreign liabilities to GDP, which has surged in recent years. So far the dollar has fallen by 15% in trade-weighted terms against a broad basket of currencies. Nevertheless, after adjusting for inflation, its value is still close to its 30-year average. It may need to fall by another 20% over the next few years if the current-account deficit is to be halved (see article).
American policymakers seem happy to let the dollar slide. Europeans, however, complain that the burden of adjustment has fallen disproportionately on their currency, the euro. As the euro has soared against the dollar, central banks in Japan, China and other Asian countries have bought dollars to hold down the value of their own currencies. By doing so, they financed over half of America's current-account deficit in 2003. Without that money the dollar would have fallen further.
Missing signals
In the short term, Asia might thus be seen as America's saviour. But in the longer term Asian governments are delaying a necessary adjustment by allowing America's deficit to loom large for longer. This is likely to lead to an even bigger and more dangerous build-up of American foreign debt.The behaviour of Asia's central banks has also blunted the necessary market signals to which even America must, eventually, pay heed. The current-account deficit is a direct, arithmetical reflection of insufficient domestic saving. In particular, America needs to prune its government budget deficit. However, it feels even less reason than usual to do so. Normally, when a government's budget deficit swells so fast (to 4.6% of GDP this year, from a surplus of 2.4% of GDP in 2000) and its currency is falling, investors would demand higher bond yields to compensate them for the increased risk. That penalty gives governments both a warning and an incentive to borrow less. But Asian governments are devouring American Treasury bonds with little regard for the usual risk-return characteristics. As a result, bond yields are being held artificially low, subsidising America's borrowing spree.
This has allowed the Bush administration to point misleadingly to low bond yields as evidence that its budget deficit is not harming the economy, and to think that cutting the deficit is less urgent. President George Bush's plan, set out this week in his budget, to halve the deficit over five years is based on unrealistic assumptions and fantasy accounting (see article). A fiscal stimulus was justified when the American economy was on the brink of a deep recession in 2001, but now that the economy is booming again, borrowing needs to be cut.
Asia's game
In essence, Asian governments are buying American Treasury bonds in order to ensure that Americans can afford to keep spending money on Asian goods. This cannot go on forever. Despite their mercantilist instincts, sooner or later Asia's central banks will have to face the fact that they are holding far too many risky, low-yielding dollars. If they stop buying, it could trigger a sharp fall in the dollar and a jump in bond yields. Delaying the natural adjustment in the dollar and bond yields is likely to mean that, when the inevitable correction comes, it will be much more painful.If financial markets do turn nasty, then everybody will carry some of the blame. Japan and China will be guilty of trying to block market forces and hence an earlier adjustment in America's trade deficit. With Japan's economy now growing faster than the euro area and its firms' profits surging, Japan can probably afford a stronger yen. Its continuing worry about deflation can be better addressed by printing more money. And China needs to allow its currency to move upwards, not just to help the rest of the world, but also to rebalance its own overheating economy. Without such a rebalancing, inflation or a property boom and bust could destroy growth. The Chinese might find it easier to accept such advice if they are given a seat at the G7 table, where they clearly belong.
The euro area is also far from blameless. Policymakers wring their hands about the “brutal” rise in the euro, yet the euro is still close to fair value against a basket of currencies. If Europeans are worried that a stronger euro will hurt their economies, then the solution is simple: the European Central Bank should cut interest rates to boost demand.
However, America must bear much of the blame for its failure to do anything to curb household and government borrowing and so boost saving. Its easy monetary and fiscal policies are now beginning to look reckless. The dollar's slide has rightly shifted some of the burden of economic adjustment on to other economies. Sooner or later, though, America will have to face up to its own responsibilities, too.
More from The Economist print edition, as they report on the G7 meeting in Boca Raton, Florida. Follows nicely on the opinion column.
Competitive sport in Boca Raton
Europeans think the dollar is in danger of becoming too weak; Americans disagree. Who is right?
ALAN GREENSPAN and John Snow, respectively the chairman of America's Federal Reserve and the secretary of its Treasury, will be challenging their European counterparts to a game of tennis when the finance ministers and central-bank governors of the G7 group of rich economies meet in Boca Raton, Florida, on February 6th and 7th. But the swing of their rackets will be less on the minds of American and European finance officials than the swings in their currencies.
The euro has risen by 50% against the dollar since its trough in July 2001. European officials are frustrated by America's lack of concern for the dollar's slide and the disproportionate burden this is imposing on the euro. In the run-up to the Boca Raton meeting, some European policymakers were calling for a joint statement to stabilise the dollar. But this seems likely to have fallen on deaf ears. As John Connally, a former treasury secretary, told the rest of the world in 1971: “The dollar is our currency, but it is your problem.”
Although the dollar has strengthened against the euro over the past two weeks—thanks to slightly more hawkish comments about interest rates from America's Fed and efforts by the European Central Bank to talk its currency down—its slide has quickened since the G7's previous meeting in Dubai last September. Then officials called for “more flexibility” in exchange rates, but they have since disagreed about what that really meant. John Snow initially described the statement as a “milestone change”, sending out a general signal that the dollar needed to fall further.
Others interpreted it as a veiled message to China and Japan to stop intervening in the foreign-exchange market and let their currencies rise. If indeed that was the message, both countries chose to ignore it. China's currency, the yuan, remains rigidly pegged to the dollar while the Japanese continue to buy dollars galore in order to hold down the yen.
A new agreement on exchange rates at this weekend's meeting seems unlikely given that the G7 members (America, Britain, Canada, France, Germany, Italy and Japan) have such different goals. The Americans do not see any problem for the moment in letting their currency fall, while the Europeans want action to stabilise it. Japan, meanwhile, is single-mindedly continuing its massive intervention in the currency markets.
A level playing court
When the dollar first started to wobble, in early 2002, America's economy was weak. Today, however, it is growing far faster than the economies of the euro area and Japan. So why is the dollar still sickly?The obvious answer is that investors are less eager to finance America's vast current-account deficit than they once were. Given that stronger growth in America than elsewhere could cause that deficit to swell still more this year, a fall in the dollar is both inevitable and necessary to reduce the deficit by making imports dearer and exports cheaper.
Nevertheless, European policymakers complain that the euro has borne a disproportionate share of the dollar's decline. The Australian dollar has actually seen the biggest gain against the dollar among the main currencies (see chart 1). But since January 2002 the euro has risen against the greenback by roughly twice as much as the yen, sterling or the Canadian dollar. The currencies of emerging Asian economies other than China have also moved only a little, while the Mexican peso has even fallen against the dollar. (Mexico is America's third-biggest trading partner.) Overall, the dollar has fallen by a modest 15% against a broad basket of currencies.
There is also a deeper policy rift between Europe and America over a different sort of burden sharing. America accuses the euro area of running overly tight economic policies and hence not pulling its weight in supporting global growth. Europeans, on the other hand, fret that America's lax monetary and fiscal policies, by depressing domestic saving, are perpetuating its current-account deficit. They fear that American policymakers' belief that the dollar and the deficit will adjust smoothly is overly complacent.
Who's winning?
For at least a decade, American treasury secretaries have preached the virtues of a strong dollar. Yet today America is thriving on a weaker dollar. The lower exchange rate is already boosting exports and profits: export volumes rose at an annual rate of 19% in the fourth quarter of 2003, while imports grew by 11%. Moreover, by making manufacturers more competitive, the weaker dollar should create jobs before the presidential election in November.Better still, there seems little imminent danger that a sliding dollar will cause inflation to surge. The economy has ample spare capacity; inflation is, if anything, currently too low. As yet the weaker dollar has not pushed up import prices. Foreign exporters tend to fix their prices in dollars, and fierce competition has encouraged them to hold these down. Instead, they have trimmed their profit margins. One bizarre result is that some top-of-the-range German cars are now almost 30% cheaper in America than they are in Europe. But there is a limit to how much firms can squeeze profits; eventually a falling dollar will push up prices, so reducing imports.
If the cheaper dollar is benefiting America, is it hurting the euro-area economies? Surveys suggest that European firms are not yet panicking about the strength of the euro. An index of German business confidence tracked by Ifo, a German research institute, has risen to its highest level for three years. However, another survey by the institute found that 90% of larger German manufacturers would have problems exporting at a euro-dollar exchange rate above $1.30.
The current “strength” of the euro (at around $1.25) is often exaggerated. As recently as 1995 the currency (as calculated from a basket of the national currencies that preceded it) was trading much higher, at the equivalent of $1.37. The euro's trade-weighted value today is roughly the same as it was at its launch five years ago. In 2002 the European Central Bank (ECB) examined 16 different studies into the fair value of the euro. Most said it lay in the range $1.10-1.20, which explains why European policymakers have only recently got nervous about the euro's rise.
The ECB needs to worry about the strength of the euro only to the extent that it affects inflation. In January, the average inflation rate in the euro area was 2.0%, just above the central bank's objective of “less than but close to 2%”. In theory, a stronger euro could be beneficial if it helps to hold down inflation and allows the ECB to cut interest rates. But, as in the United States, currency movements appear to have a more muted impact on European inflation than in the past. This is largely because importers have changed their pricing behaviour. They tend to keep their prices fixed in euro terms, thereby enjoying an increase in profit margins as the euro climbs rather than an increase in market share.
If the euro continues to rise, the ECB could intervene in the foreign-exchange market and buy dollars in order to signal that the currency is no longer a one-way bet. But that would probably not succeed unless America were to join in—which currently seems unlikely. If the ECB is really worried about the impact of a rising euro, then its best weapon is to cut interest rates. Most economists, however, do not expect it to act until inflation falls below 2% and there is firmer evidence that the euro's strength is hurting business.
For its part, Japan cannot cut interest rates because they are already at zero. Instead, the Ministry of Finance has been intervening in the foreign-exchange market on an unprecedented scale. After $175 billion-worth of purchases in 2003, it spent another $67 billion in January this year, a monthly record. That has not, however, prevented the dollar from falling to a three-year low of ¥105.2. Now the ministry is seeking more ammunition in its battle to hold down the yen. It has asked for authorisation from parliament to increase the funds available for intervention in 2004 to ¥61 trillion ($580 billion).
These efforts to hold down the yen are annoying European policymakers because it will then require an even bigger rise in the euro to reduce America's current-account deficit. A year ago, when Japan's deflationary economy was still flat on its back, there was a strong case for intervention to hold down the yen. But many economists are now forecasting that Japan's GDP will grow by 2.5% this year, following 2.4% in 2003. As recently as May last year the consensus forecast for both 2003 and 2004 was a mere 0.7%.
The good news about Japan's economy is increasingly broad. The unemployment rate fell to 4.9% in December from 5.4% last May, and the ratio of job offers to applicants rose to its highest level for more than ten years. In December, Japan's export volume was 13% higher than a year earlier, and the trade surplus was 40% bigger. Even deflation has eased.
Goldman Sachs, an investment bank, argues that a strong yen is less likely to derail Japan's recovery today than it was in the past because firms' output and profits have become less sensitive to swings in the dollar. China is an increasingly important market for exporters, and investments in America (such as car plants) have helped insulate firms from a rise in the yen. Many analysts reckon that Japan's big exporters could cope with a dollar rate of ¥90.
So why is the Japanese government intervening on such a vast scale? One reason may be concern about the possible impact on equities if the yen were to dip below a supposed psychological threshold of ¥100. A relapse in the stockmarket would erode the capital of Japan's shaky banks.
The ball in China's court
But Japan is not the only one trying to resist market forces. The Chinese yuan, the Malaysian ringgit and the Hong Kong dollar are all pegged to the greenback. Other Asian currencies officially float, but their central banks have also been intervening heavily to hold them down. The total reserves of the big four—China, Japan, South Korea and Taiwan—have more than doubled over the past three years (see chart 2), to $1.5 trillion, most of it held in American government securities.
It is hard to judge the correct value for the Chinese yuan, but there are tell-tale signs that it is undervalued. One is China's rapidly rising reserves; another is its large surplus on its “basic balance”—the sum of its current-account surplus and the net inflows of long-term capital, such as foreign direct investment. Its basic balance currently stands at around 4% of GDP.
In a free market the yuan would surely rise, helping to spread the burden of the dollar's adjustment. But the Chinese government's priority is to create new jobs as unprofitable state firms are closed down. For that it needs to maintain the currency's competitiveness. Furthermore, until China's shaky banks are shored up, it would be foolhardy to let its currency float.
Until then, any currency adjustment is likely to be modest. At best there might be a small widening of the yuan's band against the dollar or a shift to peg the yuan to a basket of currencies, but without any significant appreciation. So long as the yuan remains more or less pegged to the dollar, other Asian economies will resist appreciation too.
Stuffing reserves under the mattress is not without cost. The return on American Treasury securities has been poor. There is also a limit to how long this policy can continue. Large inflows of foreign exchange are creating excess liquidity in China. Some economists worry that rapid money growth is fuelling asset-price bubbles (in the property market, for instance) and causing the economy to overheat.
Where does the buck stop?
Most economists expect the dollar to fall further. Taking the average forecast of seven American and European banks, the euro is expected to trade at $1.32 in 12 months' time, and the dollar to be at ¥101. Even if they are right, the buck is unlikely to stop there. For it would still not have fallen by enough to make a significant dent in America's current-account deficit.
The maths behind America's trade deficit is daunting. The gap between merchandise exports and imports is now so large that, according to J.P. Morgan, exports need to grow almost twice as fast as imports merely to keep the trade deficit constant. Yet the dollar is still far from cheap: in real trade-weighted terms it remains close to its 30-year average (see chart 3). If the deficit is to shrink, then America's domestic demand has to grow more slowly than that of its trade partners, or the dollar needs to fall further, or a combination of the two.
Deutsche Bank argues that America does not need to eliminate its current-account deficit. The German bank reckons that it could probably sustain a deficit of around 2.5% of GDP, half its current level. Using the OECD's economic model, the bank first assumes that the dollar falls to $1.45 against the euro by 2005 and then roughly stays there. This would reduce the current-account deficit to a still hefty 3.6% of GDP by 2008. To reduce the deficit to 2.5% of GDP would, according to Deutsche Bank's simulation, require the dollar-euro rate to fall to $1.98 by 2008, supposing that the dollar falls evenly against all currencies and nothing else changes.
But this assumes that all the adjustment has to come through the exchange rate. The current-account deficit basically reflects America's lack of saving, by both households and the government. Not only is the government's budget deficit set to soar to a record $520 billion (almost 5% of GDP) this year, but the personal saving rate fell to only 1.3% of income in December, thanks to rampant consumer borrowing.
Another way to slim its external deficit is for America to save more. Suppose the government were to reduce its budget deficit to 1.5% of GDP in 2008. Deutsche Bank calculates that the dollar would then have to fall to $1.64 against the euro by 2008 in order to reduce the external deficit to 2.5% of GDP. If the Asian currencies continue to cling to the dollar, the euro would have to rise by even more.
This is only a crude simulation; other factors may change at the same time. However, many other economists agree that, even if the American government were to trim its budget deficit (and thus dampen growth in domestic demand), the dollar would need to fall by another 20% in trade-weighted terms in order to achieve a sufficient reduction in America's current-account deficit. To put that figure into context, remember that the dollar fell by over 50% against the D-mark between 1985 and 1987, when America's current-account deficit was smaller (at only 3% of GDP). This time the dollar has fallen from its high point by just over 30% against the euro.
In an ideal world, America would now tighten its monetary and fiscal policies in order to boost saving, curb domestic spending and reduce imports. This could be offset by looser policy in other countries. But big budget cuts do not happen in election years. So it could take an even bigger fall in the dollar to correct America's current-account deficit.
The problem facing the dollar, therefore, is not that it is too weak, but that it remains too strong. In propping it up, the policies of Asian governments are delaying the necessary adjustment of global imbalances. America is being encouraged to remain profligate for longer. Unlike private investors, Asian central banks care little about the financial return on their dollar reserves. Their sole concern is to keep their exchange rate stable in order to bolster domestic economic growth.
No discipline from bonds
This is distorting financial markets: the dollar remains too high and America's cost of capital is artificially low. Previous falls in the dollar's exchange rate have pushed American bond yields up as foreign investors have demanded a bigger reward to compensate for the increased exchange-rate risk. This devaluation, however, has so far been painless with bond yields staying remarkably low. Ten-year Treasuries, for example, are currently yielding 4.1%, slightly less than the yield on comparable German bonds.In 2003, Asian central banks financed well over half of both America's current-account deficit and its budget deficit. At their recent pace of intervention, Japan and China could buy enough Treasury bonds this year to more than cover the American government's new borrowing needs. This would allow America to continue borrowing recklessly without the usual warning sign of rising bond yields.
President Clinton's campaign manager, James Carville, once quipped, “I used to think if there was reincarnation, I wanted to come back as the president or the pope...but now I want to come back as the bond market. You can intimidate everyone.” Thanks to the appetite of Asian central banks, however, the bond market has lost much of its bark. It is subsidising rather than punishing American profligacy.
Not only do artificially low bond yields appear to offer false signals that America's budget deficit is no cause for concern, but by holding down mortgage rates (which are linked to bond yields) they are also prolonging an unsustainable boom in consumer spending and borrowing. This benefits America in the short term, but allows even bigger imbalances (in the shape of domestic debt and foreign liabilities) to build up in the long term. To contain these debts will eventually require a far sharper collapse in the dollar, a steeper rise in bond yields, and a harder economic landing. Anyone for tennis?
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