David R. Kotok
There are 2 Two Front Wars!
http://www.NewsAndOpinion.com | Things are getting hotter.
A North Korean Jet violated S. Korean airspace yesterday. The South Koreans scrambled their fighters and the North Korean jet returned to within its boundaries. This is happening as Colin Powell is headed for Asian talks about the N. Korean situation.
China has told the U.S. it should engage in direct talks with N. Korea. We hope President Bush is listening. U.S. policy in Asia has to be be handled much differently than in the Middle East. Iraq is not North Korea.
But Iraq is coming to a head and Bush has staked his presidency on the outcome. It is hard to see how Bush could be reelected if Saddam Hussein is leading Iraq next year. Something here has to give and we believe it will happen soon. Get ready for the shooting to start.
Meanwhile, the euro is strengthening again as we believe it should be. It's back above 1.08 today; our forecast by yearend 2003 is 1.15 to 1.20. Don't be fooled by any dollar rally when the Iraq War starts. It will be temporary.
Compare the following:
1. Our Federal Reserve driven policy interest rate is the Federal Funds rate and it is currently 1.25%. The European Central Bank's policy rate is 2.75% and was reaffirmed there on Feb. 6th.
2. The euro zone headline consumer price inflation measure is 2.1%. Our headline CPI is 2.6% unadjusted and 2.2% using the new chain-weighted adjusted method. We'll use the lower number for this analysis.
3. We in the U.S. calculate our consumer inflation by making hedonic (quality) adjustments and the Europeans do not do so in the way we do. The difference is estimated at about a 1/2 a point in the stated inflation rate. In other words, if we did it their way, our inflation rate would be a half point higher than we say it is or, if they did it our way, their inflation rate would be a half point lower than they say it is.
4. Using our estimated half point adjustment we get an inflation adjusted policy interest rate in the euro zone of plus 0.65% (2.75% minus 2.1%). In the U.S. we get a negative policy rate of 1.45% (1.25% minus 2.2% minus a half point adjustment). For the 95% of the population of our planet that do not live in the U.S. or Europe, money held in U.S. short term instruments is losing value (buying power) every day while money in equivalent euro denominated instruments is gaining value every day.
Conclusion: the inflation adjusted central bank policy rate is an indicator of tightness or looseness of monetary policy. It is only one indicator but it is one of the most important ones. Clearly, the ECB is maintaining a tighter policy than our Fed. It has been doing this for several years as part of its mandate. Central bank policy makes the euro a stronger currency than our dollar.
Conclusion: in a world of high war and terrorist risk, in a world of a two front war, in a world where the largest economy (United States) is running a current account deficit of 5% of its GDP, in a world where America "requires capital inflows of 80% of the world's investable capital" (Thank you, Bridgewater)---in such a world the policy driven stronger currency will appreciate in value against the policy driven weaker currency.
The dollar will get weaker, the euro stronger. This is not favorable for U.S. long term interest rates.
Grab your helmets. The two front war will be in geopolitics AND in currency.
JWR contributor David R. Kotok is President and Chief Investment Officer of Cumberland Advisors, Inc. His articles and financial market comments have appeared in The New York Times, The Wall Street Journal, Barron's, The Bond Buyer and numerous other publications. He can be seen on CNN, CNNfn and CNBC. Comment by clicking here.
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