NEWS / Foreign Exchange

The Dollar's New Low Yield Status

Explaining the dollar??™s new low yielding status

We received several comments and inquiries related to our statement late last week indicating the dollar??™s new status as a low yielding currency and, hence a carry trade candidate. Despite the dollar??™s absolute rate advantage over some currencies (CAN, JPY and CHF), it is the expectations of further currency losses that is expected to erode the remaining rate differential. The fact that the US fed funds rate, now at 4.75%, is higher than its counterpart in Canada (4.50%), Eurozone (4.00%), Japan (0.50%) and Switzerland (2.75%), the anticipated reduction --and erosion -- of the U.S. yield advantage is the main driver of the dollar??™s deepening losses, which outweigh the current yield advantage of the dollar over these currencies. A 25-bp Fed cut this week will bring US rates to the same level as Canada for the first time since February 2005 and reduce the dollar??™s yield advantage over that of the Eurozone to the lowest level also since February 2005. Thus, FX carry trades not only thrive on the anticipated reduction in a nation??™s interest rate vis-? -vis other nations, but also in the resulting decline in the value of that currency ahead of further rate reductions.

The onset for prolonged Fed rate cuts is similarly matched by the likelihood of non-US interest rates remaining unchanged, or even rising in the short-term as is the case of Australia . The unwinding in US housing continues unabated from a perspective of falling prices, falling sales of new and existing homes, increased months??™ supply and falling construction jobs. Today??™s latest advance in gold to a fresh 28-year high (January 1980) of $798 per ounce at the NY Comex is clearly a manifestation of the deteriorating dollar fundamentals and outlook. Indeed, soaring gold prices have also been driven by falling production (lowest in 10 years), slower rate of selling by global central banks and record high interest by purchases of ETFs and futures contracts.

Why we expect the Fed to go 25-bps?

We expect the Fed to cut the Fed funds rate by 25-bps to 4.50% and the discount rate by 50-bps to 4.75% due to the following:

1. The Fed needs to keep its powder dry ahead of further deterioration in housing (which so far has eluded the Fed??™s forecasts). Aggressive rate cuts this year, could subject the dollar to accelerating selling pressure by central banks, prompting a run on the currency and threaten the foreign financing of the current account deficit. Rapid declines in short-term rates would also mean excessive steepness in the US yield curve as long-term yields push higher on reduced demand for long-term treasuries.

2. Other arguments for not expecting a half point move is the relatively lofty levels in US stocks. The S&P 500 is currently 4% higher than it was on September 18 before the FOMC announcement. There is also more stability in the LIBO and CP market.

3. The Fed will want to wait and see the latest data on payrolls, ISM reports and as well consumer spending data before committing to a more aggressive move. Thursday??™s release of September consumer spending is expected up 0.4% from 0.6%, while the October manufacturing ISM (also Thurs) is seen at 51.6 from 52. Our preliminary forecast for the October payrolls is at 90K from 110K, with the unemployment rate up at 4.8% from 4.7%. While these figures suggest weakness, they do not warrant an aggressive Fed move that is more typical of emergency measures.

A quarter point move is expected to be negative for equities and the dollar, as the combination of risk aversion and anticipation of further rate cuts dictate the action in stocks and equities.

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