Is deflation behind the dollar drop?
Posted on 18. juil, 2010 by Jean Jacques Ohana in Weekly Focus | Commentaires fermés
The past month has seen a surprising dollar bearish move across the board. The dollar drop has been particularly acute against European currencies but has concerned every currency from yen to Latam. Nevertheless, this move must not be interpreted as a positive liquidity move since the most pro-cyclical currencies, i.e. commodities currencies and emerging currencies have experienced lackluster appreciation.
In turn, US yields experienced sharp drops with respect to other regions because of consistent downward revisions of the US economic outlook. Manufacturing surveys (ISM, Philly Fed, Empire Manuf) has consolidated as forecast by our predictive industrial cycle indicator, jobs creation have been poor, and real estate prices traded sideways to say the least. Globally, the economic activity surprised to the downside, China leading the way. All these bad surprises translated into deflationary pressures which have been more pronounced on US bonds than on any other.
US 2 years yields have lost ground against German and Japanese yields and both spreads have a very high explanatory power of currencies variations.
Therefore, the dollar move must be interpreted as a crisis of defiance towards the US economy and its ability to recover in the long run. Indeed, new talks of quantitative easing have resurfaced within the Federal Reserve and deflation becomes a credible scenario given the plunge in yields: 0.60% in a 2 years maturity, 2.9% in 10 years.
Moreover, risk aversion, while being still elevated, has clearly receded in European sovereign debt. Recent Greek and Spanish debt issues have been successful. These developments are new signs that the liquidity crisis has been managed as reflected by the relief of the CDS of most vulnerable European countries:
However, solvency risk is now reinforced by the recent dollar depreciation as it prevents Club Med countries from improving their trade balance and in turn reducing their public deficit. The consequence is a higher deflationary pressure with a negative impact on the public debt burden and on the domestic banks’ balance sheets.
The sharp dollar depreciation is not an automatic stabilizer but an endogenous explosive process that reinforces European vulnerabilities. An imminent sharp EUR/USD reversal is a likely outcome, the banks stress tests results on July 23 may be the trigger…
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