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Comment: Cinderella without a clock

John R.Taylor, Jr., Chief Investment Officer, FX Concepts, Inc.  examines the global  impact of rising US interest rates and forecasts the decline of the dollar.

Last month Warren Buffet caught our fancy, while encapsulating our outlook, by commenting that the carry trade was "like Cinderella at a party with no clocks." In that case, he commented, "it is very hard to leave early."

With the violent downward correction in emerging market bonds and equities during this past week, and the twitchiness in most developed equity markets as well, it is possible that the clock is starting to chime midnight. But, we think it is too early.

The problem is, as Buffet stated, we can't be sure. We don't know what time it is. We are using the term "carry trade" in a broad way, as financing a house with floating rate debt is a carry trade. When a corporation issues fixed rate debt, and then swaps it into paper whose rate is based on one month Libor, it is entering a carry trade.

Banks have been in this business for years, but now many near-banks, non-banks, and hedge funds are in it too. Everyone participates in this strategy because the payoff is so high, and looking back over the past few years, the risk has been so low.

Today overnight money is near 1.00% while five year US Notes are around 4.00%. With returns like these, leveraged many times over, the whole world sits up and pays attention. Because the carry trade is so profitable, and capital projects are so easily financed, the economy is running away with excitement.

Nominal growth rates over 6% are way above the cost of short-term money, and this leads to more growth. To slow the economy, short rates should be around 4%, which is the rate that would not stimulate more borrowing, the so-called "neutral" rate.

The problem as we see it is that the Fed cannot move rates anywhere near the 4% level without causing a massive financial dislocation. Because the various carry strategies have been so profitable for so long, many of the structures that have been created for them would fail with higher rates.

One clear example is the housing market. If floating rate mortgages, now roughly 4.10% - which is 1.10% base plus a 3.00% spread, went to 7.10% - prices would collapse, builders would go broke, and Congress would be up in arms.

Many hedge funds and other financial institutions have followed LTCM's path, a bit more circumspectly perhaps, but there will be many market disruptions when rates rise. The Fed is walking a fine line, and it is possible that their goal is unattainable. In that case, the economy will either expand further in an uncontrollable fashion or will collapse under the weight of higher rates.

The Fed has told us that rates will rise slowly, but the market has forced them up rapidly, and there are the mini -panics in various weak spots, like Brazil and Turkey. We believe the Fed will follow this gradual path, but the crises will grow. Even a 1/4 point move could be enough to cause a global dislocation and turn the US economy down.

Our cycles, the best clock we know, say this will happen in the third quarter. As the economy buckles, rates will begin to drop aga in and the dollar will plummet.
The US dollar is presently being supported by the strengthening US economy and its out-performance of Europe and Japan. Because of the economic
growth, dollar interest rates have been rising, both in absolute and relative terms when compared with the euro and the yen.

It is clear that the US rates (both the 3 month rate and the 5 year rate) have been strengthening against European rates for more than 11/2 years. US rates began to rally in the fourth quarter of 2002, along with the US equity market, but the increasing attractiveness of dollar deposits did not begin to affect the dollar until the beginning of this year.

This lag, which we have discussed before, is a consistent factor in the foreign exchange market. As the lag is somewhere between one and two years on average, the rising interest rate spreads today should translate into a stronger dollar next year - all else being equal.

As we are forecasting a peak in US interest rates in July, and a decline to new lows in 2005, there will be a further dollar decline ahead. The question is when?

Of course, this is not the only factor impacting the value of the dollar. However, even if we just look at these differentials, there are some points in favor of a weak dollar. Although US rates have been climbing for a year and a half, Eurodollar rates are still below Euribor rates and have been that way for almost 4 years.

When US rates are below European rates, taking the lag into consideration, the dollar also tends to weaken. As we expect US rates to drop further below Europe after July, the dollar will decline again.

Background Note: FX Concepts was established in 1981 as a specialist in foreign exchange and interest rate research. It was one of the first to use a disciplined, quantitative approach to currency management. It is a leading currency manager with over USD 5 billion in assets under management.  Over 700 institutional research clients follow its analysis daily. 

The firm's philosophy is that currency can be successfully managed, both as a risk-control strategy and as an alpha-generator.  In 1987, the Eastman Kodak pension fund awarded it a mandate to manage the currency exposure linked to their international equity portfolio - it was in effect one of the first "currency overlay" mandates ever awarded.  Eastman Kodak remains a client, along with other well known pension plans such as the World Bank, Schlumberger and the San Diego Public Employee' Retirement System. In addition to its currency overlay, FX Concepts also manages currency as an absolute return strategy for entities such as ABN Amro, JP Morgan/Chase, UBS Warburg, Société Générale, Deutsche Bank and HSBC.

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