Jewish World Review May 1, 2003/ 29 Nissan, 5763

David R. Kotok

David R. Kotok
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Euro Stronger; Dollar Weaker: more of it to come. | The euro has broken above 1.11 Wednesday in a reaction to the announcement of the size of the U.S. Treasury borrowing. This should have been the top of the news, but it was not.

Long time readers know we have been bearish about our dollar and bullish about the euro for several years. We continue to hold that view. For the rest of this year we expect the greenback to weaken against many currencies.

Where it will stabilize against the euro is uncertain; it could be much higher than the present level.

Recall a little history for guidance. Start with the official date when the treaty among the eleven original European Monetary Union countries was set. Then, the exchange rate among those eleven currencies became fixed which allowed for a computation of the theoretical exchange rate between the euro and the dollar. If you go back that far (mid-1990s) you can start to track the euro/dollar rate at 1.37. That means it would have taken one dollar and thirty seven cents in U.S. currency to buy the basket of the original eleven country currencies that were set according to the initial terms of the Maastricht Treaty.

The euro fell in value against the dollar immediately and continued as the virtual euro was launched. When the electronic euro started to trade the exchange rate was 1.18 dollars for each euro; that rate lasted only one day. Within the three year period that the electronic euro was used but the paper euro was still not deployed, the exchange rate fell to the low 80 cents range.

Since the paper euro was introduced, and since it became an immediately accepted currency, we have seen the euro start to strengthen against the dollar. Each euro costs an American about 25 cents more now than it did during the low period two years ago.

Today we have a situation where the European economic outlook is weak and the U.S. outlook is problematic. At the same time the borrowing requirement in the U.S. is exploding both directly and relative to European requirements. To measure this borrowing need we have to look at the public borrowing through European eyes. There they add the entire public sector to measure the impact on the debt markets.

Here we tend to distinguish federal debt from state and local. Our state and local deficits this year are estimated to be as much as 73 billion. We finance most of it on the backs of wealthy individuals because of the tax code which has created the tax-free municipal bond while limiting the ability of institutions to buy it. Add that to the 300 plus billion federal requirement which is taxable debt and one begins to see how big this issue has become.

All this means that foreign investors are now evaluating their allocations between the dollar and other currencies and deciding if they want to redeploy monies out of dollar holdings and into something else. The "something else" could be the Swiss or Norwegian or British currency but the biggest and deepest currency is the euro which is why we see these inflows into the euro and out of the dollar. That is why the euro is rising in price or, to say it another way, the dollar is falling. "Falling" or "rising" all depend on your viewing platform.

Bottom line. Our government is going to be engaged in record financing at a time when foreigners are likely to be increasingly reluctant to absorb more dollar debt at the current price (yield). The Fed can offset this of course and has unlimited ability to buy federal debt by creating the money to do so. We expect to see more of this Fed action as the treasury refunding unfolds.

Since the Fed is worried about the domestic U.S. economy first and foremost, it will benignly ignore the weakness in the currency. We expect Fed officials to continue to offer the idea that the currency value is in the hands of the Treasury Department and not the Federal Reserve. We also expect the Treasury officials to mouth the usual "strong dollar is in the interest of the U.S." line while quietly looking the other way as the dollar falls.

Longer term implications for the dollar denominated debt of the world's largest borrower (that means us) is not benign. Of course, we will be able to finance ourselves. The issue is price. And that translates into the yields that will be required to sell the new debt.

Bond interest rates will probably stay around present levels in the short term because the Fed will see that they do. Rest assured that the Fed will assist the Treasury in accomplishing the forthcoming financing.

In the longer term bond interest rates are headed higher.

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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01/16/03: Bush plan and tax-free bonds: Impact negative.
12/13/02: Frequently Asked (financial) Questions
12/11/02: The Fed, The New Bush Folks, The Policy
12/05/02: Five easing pieces
11/26/02: Lessons Learned at The Philadelphia Fed and an update to our strategic outlook
11/22/02: What happens when you mix politics and municipal bonds
11/20/02: Secular vs. Cyclical Bull and Bear Markets
11/14/02: Please stop bashing the ECB!
11/08/02: Fed may have taken themselves out of debate but they've added to uncertainty by surprising the markets
11/07/02: The election and the Fed: Both validate stimulus
10/31/02: Welcome to the world of an enlarged and open Europe

© 2002, David R. Kotok