A.G. EDWARDS & SONS, INC.
One North Jefferson, St. Louis, Missouri
314-955-3050
(March 21, 2002) CURRENCIES: One of the critical issues for the financial markets is when does the Federal Reserve tighten credit? Clearly, the future decisions on monetary policy will affect the debt markets, but it will also impact the dollar as well, but not in ways you might expect. Normally, the central bank keeps rates about 200 bp over the core inflation rate. Currently, this rate is running around 2.6% to 2.7%, implying a fed funds rate of 4.50% to 4.75%. Given a current target of 1.75%, the current "real" fed funds is nearly -100 bp. This suggests that, once the Federal Reserve moves to increase rates, they will have a great deal of ground to cover.
The Dollar And Real Fed Funds
Chart courtesy of A.G. Edwards.
This chart shows the NYBOT dollar index and fed funds less the core rate of inflation. As the chart suggests, we have had two instances where the FOMC has moved from persistently easy to tight policy, as shown by the shaded areas of the graph. In 1977, following the recession of 1973-75, the Fed tightened credit, taking the real core fed funds from negative to positive. The dollar index declined from 103.75 to 85.50 by early 1980. The second event occurred in 1994. Due to concerns over the Savings and Loan industry, the Fed supplied ample liquidity to the markets. In late 1993, they began to tighten rates, and increased rates rapidly. The dollar index dropped about 13.00 points, from 95.00 to 82.00.
Why would moving from easy policy to tighter policy weaken the dollar? Most likely, the market would see this action as growth retarding, from a policy that was excessively growth supportive. This change would make the dollar less attractive to foreign investors, and would likely pressure the currency lower.
A similar situation could be developing now. The European Central Bank (ECB) has not eased as much as the Federal Reserve, and the Euro FX has declined because of it. U.S. policy was seen as being more pro-growth. However, if the FOMC decides to move quickly to resume "normal" policy, it will tend to depress growth. Or, if they are seen as being slow to constrain growth, it could raise fears the Fed is giving in to inflation pressures, and make the ECB look more prudent. This would also adversely affect the greenback.
Obviously, it is difficult to make a definitive forecast with a sample of two. However, our analysis, coupled with recent protectionist actions taken by the Bush Administration, could hurt confidence in the greenback. Our analysis suggests that the dollar tends to hold its lofty levels until real rates turn positive. Thus, it may be several months before the dollar falls sharply. However, the data also suggests little risk of an upward spike in prices, which is supportive of short dollar positions.
Due to the current high correlations of the Euro FX to the dollar index, we are currently long two positions in the June contract, from 8790 and 8700, risking to 8600, with an objective of 9300.
Bill O'Grady www.agedwards.com