US dollar: changing our view

When a liquidity bubble bursts, the economic damage can be serious. With the collapse of securitisation, a breakdown of trust within the financial system and a housing market which is now seriously weak, there are good reasons to worry about the outlook for the US economy.

The debate about technical recession is irrelevant. What is more important is the likely length of any adjustment. Evidence from other countries suggests that, even with significant interest rate cuts and looser fiscal policy, a liquidity hangover can be long and drawn-out. This points to a W-shaped story for the US economy - the occasional ray of hope in an otherwise prolonged period of weak economic growth.

Built on a mountain of debt, the US upswing was bound to come to an end at some point. The collapse in securitisation over recent months has led to a massive shift in financial conditions which suggests we are in for a bumpy landing. The latest US cycle has been of inferior quality.

On the demand side, the pace of consumption, investment and export growth has, overall, been lacklustre by past standards. On the supply side, the trade-off between growth and inflation has deteriorated and productivity gains may not be sustainable. Foreign investors who bought into the US recovery have found themselves with, in some cases, worthless pieces of paper linked to a collapsing housing market.

Despite valiant efforts from the Federal Reserve, the financial system is in great difficulty. The loss of trust in asset-backed securities and the hoarding of cash point to downside risks for nominal economic growth.

Ultimately, the current downswing is a return to the unfinished business associated with the last recession in 2001. Then, consumers carried on spending, helped along by low US interest rates, rapid house price gains and the effects of securitisation. Now, as the housing market implodes, consumers are suddenly incredibly vulnerable.

This will be no ordinary downswing. Unlike the quick 'in and out' Vs that investors hope for, the financial crisis points to a longer, more drawn-out, affair. Policy measures will boost activity from time to time, but we think the best letter of the alphabet to characterise what lies ahead is a 'W'.

Compelling evidence to support this view comes from the experience of other countries who have found themselves in a similar situation. Banking crises do not respond quickly or easily to reductions in interest rates, or to aggressive fiscal loosening. Moreover, the US also has to contend with higher commodity prices which, in our view, are more a threat to growth than to inflation. We now expect GDP growth of just 1.5 per cent in 2008 and a paltry 1.2 per cent in 2009. Unemployment is set to rise to 6.6 per cent in 2009 and Fed funds will eventually come down to just one per cent.

Looking at the currency, the tide has now shifted against the USD. We originally looked for the USD to tread water in the first quarter of this year, but the aggressive decline in the US growth outlook has seen the USD's fortunes take a turn for the worse. In this context, we have factored in a slightly weaker USD profile for the coming months, but still believe the USD will recover gradually later this year. In our view, the USD's risk premium has justifiably risen but the pendulum will swing more in its favour later this year.

Volatility is increasingly pushing the currency focus away from nominal interest rate differentials. With rising inflation in some economies and faltering growth in others, the market has turned to policy-makers for guidance. Policy-makers' wishes for the path of G10 currencies are more or less being fulfilled.

On the other side of the spectrum, the Fed is cutting rates and boosting the economy through fiscal policy - once more the accommodating FX market is delivering the desires by weakening the USD. This type of behaviour by the FX market can switch very quickly. We believe once the pendulum swings back from decoupling to contagion this type of accommodating behaviour will break down.

Our research shows that often the Eurozone economy reacts with a lag to US data and the idea that Eurozone can escape unscathed is far-fetched. Once the pendulum swings to contagion again, GBP and the EUR in particular will come under substantive pressure from a rejuvenated USD.

This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.