Forex Investment and Currency Trading

• While the weak US housing market and associated credit crisis had a short-term impact on the USD, the more important impact is likely to unfold during the years ahead.
• High levels of consumer debt service and reduced credit availability suggests a sluggish consumer spending recovery and a gradual rise in the US savings rate that should be associated with improving trade and current account deficits.
• The emergence of developing economies as sources of demand should allow US export growth to persist, also aiding the adjustment of global imbalances.
• Narrowing structural deficits and sluggish domestic demand growth would be consistent with only a gradual USD recovery during the years ahead.

There is little doubt that the effects of the credit crisis that began in mid-2007 had a significant influence on USD performance over the last 10 months. In the first week of August 2007 the December 2008 Fed funds future contract traded with a high yield of 4.75% - it currently trades at about 2.15%. This represents a 260bp reduction in the expected Fed funds rate that actually lags somewhat the actual 325bp reduction in the Fed funds target rate that took place over that period. At a time when most of the world’s central banks were raising their level of concern about current and future inflation, the US Federal reserve was out-of-step, focusing their greater concern about the downside risks to the financial system and overall growth. In this context, the more than 200bp narrowing of the US 2-year swap rate versus the weighted average 2-year rate of countries represented in the USD Index appeared to drive the USD to a record low versus a basket of developed currencies. Even the modest USD recovery in recent weeks appears consistent with a slight rebound in that key rate differential.

By itself, the record undervaluation of the USD will put into motion forces that would act to stabilize the structural imbalance between the US and its trading partners. While record high oil prices have moderated the magnitude of improvement in the nominal trade balance, the real trade balance on goods has improved steadily over recent years, with the 3-month average real goods balance already narrowing by about 16% from the - $59.9bn trough reached in January 2006. Indeed, over the 8 quarters ended 1Q 2008, the +$213.2bn rise in real exports from the US accounted for 47% of the increase in real GDP despite the fact that real exports over the
last two years accounted for only 12.0% of the level of real GDP. In other words, the contribution of rising exports to growth over the last 8 quarters was about 4 times its average share of the economy over the period.

In a normal economic cycle over the last half century that might be the end of the story. Policy easing, primarily monetary policy easing, would begin to work with a lag, domestic demand would recover and the US external balance would begin to widen again. In fact, since the onset of consistent current account data in 1Q 1960 the US current account deficit, as a percent of GDP, reached a new extreme in each of the 6 main cycles. However, there is a real risk that the current cycle will differ from past cycles, with both developments in the emerging world and the US credit crisis having lingering effects that alter the fundamental landscape during the years ahead.