by Kevin Klombies, Senior Analyst

Wednesday, April 9, 2008

Chart Presentation: The Buck

We are asked- quite often, actually- how we could possibly be positive on the U.S. dollar given the current wretched state of affairs in the U.S. housing and financial sectors. One answer might be that if the dollar continues to decline at its current pace it will eventually disappear which, we suspect, is a low-odds outcome so we can argue with some conviction that the dollar will bottom at these or lower levels. Not that this less than serious comment is much of a help.

One of our BIG views is that economic growth is driven alternately by consumer and capital spending. During consumer-driven cycles the dollar tends to be weaker while through capital spending cycles the dollar is better. We simply do not buy the argument that without rising housing prices and the concurrent profligate spending by households on Chinese-made consumer goods the U.S. economy is headed into the abyss.

At top right we show the U.S. Dollar Index (DXY) and the Baltic Freight Index (BFI) from late 1993 through much of 1996.

The BFI- in our view- represents not only the health of global trade but also the strength of the wider Asian/cyclical theme. When U.S. consumers are buying Asian-made goods hand-over-

fist shipping rates tends to be stronger along with U.S. imports.

The last major bottom for the dollar occurred in the middle of 1995 just ahead of the last intervention- in August of that year- by the Treasury on behalf the dollar. The bottom for the dollar coincided with the peak for shipping rates so our argument is that it makes some sense to look for another bottom for the dollar is, as, or when the Baltic Freight Index starts to weaken.

The chart below right shows the same comparison for the present time frame. The BFI reached a peak last November declining into January as the dollar held flat above the 75 level. On the recovery from January into March the dollar slumped to yet another low which brings us to the current time frame. The argument in favor of commodities is essentially that Chinese demand will overwhelm U.S. economic weakness. While this may ultimately prove to be true our view is that if the next move for the BFI is lower instead of higher then the dollar should do no worse than trend sideways. Put another way after months and months of working into a set up the break in the BFI followed by a stalled recovery suggests that right here and right now could easily be the cycle low for the green back.




Equity/Bond Markets

Below we show a comparison between 3-month euroyen futures, an upside down view of 10-year Japanese (JGB) bond futures, and the stock price of Mitsubishi UFJ (MTU).

The broad argument is that Japan will escape from deflation when Japanese interest rates start to rise. Short-term Japanese yields did begin to turn higher in the spring of 2006 but in response Japanese long-term bonds began to rise as long-term yields moved lower. Our point is that the best case scenario for Japan’s major banks comes from a widening of the yield spread as long-term yields rise faster than short-term yields. The worst case scenario- evident since the first half of 2006- would include rising short-term yields and falling long-term yields. All of which explains why MTU has been in a downward trend since early in 2006.

Eventually one of two things has to happen. Either the Bank of Japan returns to something close to a zero interest rate policy or Japanese long-term interest rates turn higher and push above 2.0%.

Below are chart comparisons of crude oil futures and the pharma ETF (PPH). The chart below shows the time period through the peak in crude oil prices in August of 2006.

The argument that we were attempting to make and explain yesterday revolved around HOW the pharma sector reacted in 2006 to the start of the topping process of oil prices. The chart below shows that as soon as crude oil futures reached a price peak in July of that year the PPH began to rise. When crude oil prices threatened to make new highs in August the PPH corrected slightly lower before resolving upwards once again later in the month. What we are looking for today is some indication that the PPH is starting to strengthen as crude oil prices trade back and forth between 100 and 111.