Dollar bulls continue to take the markets by the horns, driving the British pound to a 5 year low and the Euro below 1.28. Deleveraging and risk aversion have been the primary catalysts for the strength in the low yielders (US dollar and Japanese Yen) but currency bets gone wrong, repatriation and the fears of weak growth in Europe have also fueled the rally.
Although earnings from US banks has been everyone’s main focus, European banks will also be reporting earnings soon and they could face some serious losses as well, especially the ones that have recently received assistance from their local governments. Liquidity problems are usually synonymous with major balance sheet problems for banks. In the corporate sector, Citic Pacific and Latin American companies will not be the only ones to suffer losses from currency bets as they try their hands in the FX markets. The outlook for the European economies is very grim and when combined with risk aversion in the financial markets, it translates into severe weakness for the Euro and the British pound against the US dollar.
The Dollar Could Rise Another 5 Percent
After injecting a massive amount of liquidity into the financial markets, central banks are finally seeing their desired reaction as LIBOR rates fall and lending becomes more fluid. In the long run, this should help to stabilize the financial markets and restore confidence, but in the short term, there could be further dollar strength. Since the Purchasing Power Parity levels for the EUR/USD and GBP/USD are approximately 1.15 and 1.56 respectively, the dollar could rally another 5 percent before the dust settles. Furthermore, the Fed has made another announcement in an attempt to stabilize the financial markets. They changed the interest rate that they are paying on excess reserves from 75bp below the Fed funds rate to 35bp. The announcement itself was not a big surprise, but the timing was. They have could have made this announcement next week when they cut interest rates, but their decision to do so now rather than later suggests that they may be preparing for a smaller rate cut next week. Unless the Federal Reserve wants to take interest rates to zero percent, each quarter point rate cut may need to be rationed from here on forward. The Bank of Canada certainly felt this way when they cut interest rates by only 25bp on Tuesday.
How Much Will Dollar Strength Hurt Exporters?
On a trade weighted basis, the US dollar has appreciated more than 18 percent since July. The typical notion is that dollar weakness helps US exporters while dollar strength hurts them but globalization has actually changed this dynamic with some exporters now benefiting from dollar strength. The key is in their expenses because if they manufacture abroad, dollar strength reduces their foreign expenses. A perfect example is Caterpillar Inc, the world’s largest manufacturer of construction and mining equipment. In the third quarter, they actually recorded an exchange rate gain because the strength of the dollar reduced their net liability position in Europe. Google on the other hand took a big hit from dollar strength. Although the company does not export anything, more than 50 percent of their revenues come from outside of the United States. As the dollar appreciates, it reduces the value of their foreign earnings. The same is true for Yahoo.
Therefore just because a US company is export driven does not mean that the dollar’s recent strength will be a drag on earnings. At the same time, a multinational service oriented firm is just as vulnerable to currency fluctuations as an export firm.