The Greenback is taking a Pounding

Pound hits highest level since Black Wednesday
By Philip Thornton, Economics Correspondent

Sterling jumped to its highest level against the dollar in 14 years yesterday as the continued weakness in the US currency raised the chances of a two-dollar pound by Christmas. [Making the Greenback the half-pound Christmas turkey.]

"It's naked aggression in the capital markets," said David Bloom, global economist at HSBC. "We have had this low volatility and narrow trading ranges and suddenly everything has broken loose and people are trying to pin the tail on the donkey."

Sterling's rise was driven entirely by a fall in the dollar against all major currencies as speculation rose that the US would fail to achieve the so-called "soft landing". Yesterday fresh data pointed to continuing weakness in the world's largest economy. Business activity in the US Midwest contracted for the first time in three and a half years.

While a strong pound will be a boon for transatlantic shoppers, it will put pressure on companies that export to the US, which makes up 15 per cent of Britain's overseas goods sales.

For a bit of historical (not hysterical) context, consider these articles from 2 years ago:

Worldwide effects of sinking dollar
Its decline to a nine-year low is impacting everything from the price of goods at Wal-Mart to the vigor of Europe's economy.

The sinking US dollar in recent weeks has raised what is suddenly a top concern from Washington to Berlin and Beijing: Is America's currency undergoing a benign adjustment or a precipitous plunge?

So far, the dollar's slide to nine-year lows doesn't reflect panic. But some analysts say a run on the dollar is possible. And even an orderly drop could affect everything from mortgages to prices at Wal-Mart.

The good news for Americans: It's getting easier for manufacturers to sell products overseas, and more likely that tourists from Germany will flock to US National Parks.

But the downside could be significant. America, the world's leading importer of goods, is now buying them at higher prices. And if the dollar's dive makes foreign investors wary, US interest rates may have to rise to attract buyers of federal debt.

More broadly, it's a shock to the global economy. Sunday in Germany, officials from the Group of 20 industrial and major developing countries called for the United States to cut its federal deficit, which is seen as a key factor in the dollar's fall.

"There's a lot of speculation," says Michael Schubert, an economist at Commerzbank in Frankfurt. He sees some signs of a "herd instinct" developing.

The dollar is now down 50 percent against the euro since October 2000, and hit a its lowest level since 1995 against a basket of foreign currencies last week.

While the shift isn't entirely new, it has accelerated since President Bush's reelection. Some observers say the timing reflects concern that Mr. Bush - with his emphasis on tax cuts - won't be able to rein in record budget deficits.

"The general perception was that under the Bush administration there would be less concentration on tackling the two deficits," says Richard Reid, European economist for Citigroup, the world's largest financial institution.

He was referring to the $412 billion budget deficit and the approximately $600 billion trade deficit the US ran in 2004. A trade deficit must be financed by other nations willing to hold US currency. And foreign investors have also been buyers of federal debt in recent years, helping to keep US interest rates low. But the trend in these deficits now looks unsustainable to many. If those investors sour, even somewhat, on holding US debt, the Treasury may need to offer higher interest on its bonds. The ripple effects, in turn, could dampen US economic growth.

The Makings Of A Meltdown

Why the danger of a stampede away from the dollar remains
While the dollar continued drifting ..., many analysts argue that it may be poised for a technical rebound as Japan, South Korea, and other nations intervene in the markets again to halt the sharp appreciation of their currencies.

How much longer, asks a growing chorus of economists, can the U.S. continue to rely on Asian central banks to finance its skyrocketing twin deficits?

"China has already diversified away from U.S. dollars," says Zhao Xijun, vice-director of the Finance & Securities Institute of Beijing's People's University. The shift has helped put upward pressure on the euro, which the Europeans are understandably concerned about: Europe has unfairly borne the brunt of the world's currency dislocations. But the Chinese move to diversify has created just a ripple in the $4 trillion U.S. Treasury market.

There are other reasons Asian central banks will probably not lead a panicky charge out of dollars. For one, Asia's economies still depend heavily on exports to the U.S. for growth and jobs. If Asian central banks stop buying dollars and send U.S. interest rates soaring, they will tank their biggest and most strategic market. "It's probable that over time central banks will want to reduce their exposure to a single currency like the dollar," says Nick Bennenbroek, senior currency strategist at Brown Brothers Harriman & Co. "But there's not much risk this will happen anytime soon."

This does not mean the scary dollar meltdown scenario will disappear. As Asian governments stepped back, hedge funds dramatically boosted their holdings of U.S. Treasuries this year. They're a far more footloose bunch than central bankers. That's why Yu's comments triggered such angst among those who see the makings of a dollar meltdown.

And as America's twin deficits continue to breach uncharted territory, "the chances of a hard landing for the dollar increase," says economist Nouriel Roubini of New York University's Stern School of Business. [At least he has remained consistent.] As Washington's borrowing needs rise, it may have to sharply raise bond rates to lure buyers. The risk also remains that some central banks with smaller U.S. holdings, such as Russia or India, would instigate a sell-off by deciding to dump U.S. assets if they sense that the dollar is ready for another big slide.

As you would hope, the Federal Reserve takes a fairly sober view of the matter, as evidenced in this study by the Federal Reserve Bank of Chicago:
Strong Dollar, Weak Dollar:
Foreign Exchange Rates and the U.S. Economy

Strong is good. Weak is bad. These generalizations sound simple enough, but they can be confusing when talking about money. Is a "strong" U.S. dollar always good? Is a "weak" dollar always bad? This publication explores how the U.S. dollar and foreign currencies affect each other and how their interaction affects you and the economy.

Weakening Dollar
Advantages

* U.S. firms find it easier to sell goods in foreign markets.
* U.S. firms find less competitive pressure to keep prices low.
* More foreign tourists can afford to visit the U.S.
* U.S. capital markets become more attractive to foreign investors.

Disadvantages

* Consumers face higher prices on foreign products/services.
* Higher prices on foreign products contribute to higher cost-of-living.
* U.S. consumers find traveling abroad more costly.
* Harder for U.S. firms and investors to expand into foreign markets.

A weak dollar also hurts some people and benefits others. When the value of the dollar falls or weakens in relation to another currency, prices of goods and services from that country rise for U.S. consumers. It takes more dollars to purchase the same amount of foreign currency to buy goods and services. That means U.S. consumers and U.S. companies that import products have reduced purchasing power.

At the same time, a weak dollar means prices for U.S. products fall in foreign markets, benefiting U.S. exporters and foreign consumers. With a weak dollar, it takes fewer units of foreign currency to buy the right amount of dollars to purchase U.S. goods. As a result, consumers in other countries can buy U.S. products with less money.

Ideally, the dollar and all nations' currencies should be valued at a level that is neither too high nor too low. Such a level would help sustain long-term economic growth and stability both here and abroad. However, this ideal is difficult to reach since many factors affect the value of a nation's money. Some of the factors are complex, but many are quite simple.

Guambat is not confident of the historical rules of thumb that pass as linkage rules by which stock markets could be expected to respond to currency changes. For instance, in years gone by, when the metal and energy commodities, which tend to be priced in US dollar terms, held strong sway over the Australian market, the stock market was keenly twitchy to currency shifts. Indeed, it tanked simply because Paul Keating compared the Aussie dollar to a Banana Republic currency (see, Bulldust and Banana Republics.

For instance, Rio Tinto blamed recent underperformance on the falling US dollar over the term of the last year, but inspite of the precipitous fall in the dollare overnight, Rio is up 46 points on the Australian market today (and is about the only stock up on the day at that). Go figure.

Weak US dollar hits Rio Tinto

The world's second-largest mining group, Rio Tinto, has blamed the weak US dollar for a 9% fall in net profit during the first six months of this year to $641m (£398m).

The Anglo-Australian miner is affected by movements in the US currency because most of its products are sold in dollars while the cost of mining its ores is denominated in Australian or Canadian dollars, or South African Rand.

In the first half of this year, those three currencies rose by 10% against the US dollar.

"The effect is that our margins are affected by currencies," chief executive Leigh Clifford told the BBC's World Business Report.

Mr Clifford acknowledged that in many situations it would be possible to hedge, by using derivatives or other financial instruments to reduce a company's currency exposure, but this was not always possible.

"The assumption is that you know where [currencies are] going and that's pretty easy in retrospect, but not so easy in prospect," he said.

Besides, "we found that, in effect, we have a natural hedge", he said.

"Typically with a strengthening of the US dollar or the Canadian dollar, that is associated with higher commodity prices.

"We've seen a little bit of that in copper and aluminium," he said.

Rio Tinto has also enjoyed strong iron ore sales in recent months, essentially due to strong demand from China.

"There is no other industry that I am aware of where China is having such a huge dominant effect, as we are seeing in the mining and metals sector," chairman Robert Wilson said.

But performance of the company's energy division was "exceptionally poor", said Numis analyst John Meyer.

The energy division earnings more than halved.

Follow-up:
The WSJ has this to say, but you need a ticket to read the whole thing:
As Dollar Weakens, Paulson Faces
Challenge of Tempering Its Decline

The dollar's continued slide against the euro and British pound highlights the delicate task faced by Treasury Secretary Henry Paulson: allowing the U.S. currency to weaken slowly against other currencies without sending it into a plunge that would damage the nation's economy.

Though Bush administration economic officials are eager to avoid a market-rattling crash, a weaker dollar could help the U.S. deflate its ballooning trade deficit by making American goods cheaper abroad and foreign goods pricier for Americans. It also could help Mr. Paulson fend off what he considers an alarming rise in protectionist sentiment.

Currency markets can respond instantly and forcefully when they sense a change in government policy or rhetoric. So even though Mr. Paulson has given no other hint that he wants the dollar to strengthen, he apparently feels obliged to repeat the strong-dollar mantra to avoid creating turmoil in the markets.

"It's very hard for the Treasury secretary to say anything about the dollar without getting into trouble," says Mr. Hormats. "It's very easy for him to do nothing about the dollar and stay out of trouble, and I think that's what they're going to do. You've got to talk the strong dollar -- and not do anything if the dollar weakens."

Frank Vargo, vice president for international economics at the National Association of Manufacturers, says the dollar's decline against the euro already is helping narrow the U.S. trade deficit with Europe in manufactured goods....

Some strategists, meanwhile, expect downward pressure on the dollar against European currencies to persist for the rest of the year as worries about the vigor of the U.S. economy mount. Yesterday's U.S. economic data, particularly a weak reading on the Chicago purchasing-managers index and a report showing a jump in the nation's number of job seekers, contributed to the dollar's decline.

"The risks for U.S. economic data in the very near term are on the downside, with recent numbers suggesting the expected recovery will be postponed to the first quarter of next year. By contrast, European data continue to come in strong," says David Woo, head of global foreign-exchange strategy at Barclays Capital in London.

Despite a call by French Finance Minister Thierry Breton for collective vigilance on the exchange-rate front, markets see little sign that global governments intend to intervene to arrest the dollar's slide. "To date there hasn't been any unified protest over the weakness of the dollar," says David Gilmore at Foreign Exchange Analytics, a consulting firm. "That is a green light to dollar sellers.

Joseph Quinlan, chief market strategist at Bank of America Corp., says a weaker dollar wouldn't be welcome everywhere. "Such a move would undercut the primary source of growth of many nations: exports" to the U.S, he wrote in a recent report to clients. "The world just isn't ready for a weaker U.S. dollar."

Seasonal factors may be contributing to dollar weakness, perhaps as European companies and investors sell dollars to repatriate profits. A research note from Barclays Capital says the dollar has fallen against the euro in the first two weeks of December every year since the euro's birth in 1999.

More Follow-up 2 Dec:

Fund managers warn of sterling impact

Sterling's rally to 14-year highs against the U.S. dollar is a significant threat to Britain's strong corporate earnings and economic growth rates, fund managers said on Friday.

But the hit to British companies with major export markets in the United States may be magnified by the fact the pound is also gaining against a range of other dollar-linked currencies in increasingly important markets in booming Asia.

"A strong exchange rate makes UK exports more expensive and UK firms could see sales into the dollar area negatively affected by the strength of the pound," Chris Iggo, senior strategist at AXA Investment Managers said in a note.

"The U.S. is a major export market but the increased importance of China and other Asian economies - whose currencies are closely linked to the dollar - suggests that the impact could be broader."

Fears over strong pound

It is making British exports to the US – such as Jaguar and Land Rover cars – expensive in dollar terms at the same time as making goods cheaper for tourists converting pounds into dollars.

A flood of bargain hunters heading for New York in the run-up to Christmas is likely to hit the British high street.

The governor of the Bank of England, Mervyn King, conceded that manufacturers were finding it increasingly difficult to sell their products in the US when he appeared before the House of Commons Treasury Select Committee yesterday.

But he pointed out that although the pound/dollar exchange rate has been volatile recently, sterling has been level against the euro.

As a result, overall manufacturing conditions appear to be "pretty stable", largely because the euro zone is enjoying economic growth.

He noted that the pound's overall effective exchange rate – which measures sterling against a basket of currencies that weights the euro as three times more important than the dollar – had been steady for quite a long time.

Mr King said that while the US was a major market for UK manufactured goods, it was not as significant as Europe, which accounts for about half the country's exports.