I continue to believe that the prospects for long-term global prosperity are better now than at any time in our history. Paul O'Neill US Treasury Sec. Jul 08, 2001

Guest Analyst
July 27, 2001

Is Contagion Catching?
Dave Lewis*

If so, should we call it a case of the Bi-Polar Dollar Bug, or perhaps the Perils of Synchronized Swimming?

During the last episode of emerging market distress, which could perhaps also be thought of as the last time the global banking community faced the risk of default, the policy response consisted of a drop in the $ especially against the JPY and a decline in G7 interest rates, led by the Fed.   As the first graph shows, the financial markets did not respond well, especially the S&P 500, which lost a quick 10% within a week as $/JPY dropped from 140 to 120, to the policy responses as the decline in $/JPY triggered widespread declines in global equity markets.  The first rate cut was also not applauded by the financial markets in that it was thought to presage further $ declines.

equity indices are indexed to 100 at Jan-5-1998 

The saving grace was the swift real sector response in both the production and consumption sectors to the rate cuts in the US as seen below with respect to the consumption side of the economy in the jump in retail sales.   The cost of this strategy, however, was further strengthening of the trend synchronizing global growth with US consumption.

So why isn't the same magic working now?

I argue, from my, admittedly distant, vantage point, that current policy is more focused on keeping the financial markets (in theory a reflection of the real economy) strong so as to maintain the appearance of economic health (talk about cart before horse thinking).  That is, in contrast with 1998, the G7 appears unwilling to let the $ drop, thereby alleviating international $ funding pressures, perhaps for fear of a repeat of the 1998 equity market response.   However, without a decline in the  $'s foreign exchange rate, the emerging markets may not recover, eventually leaving the global banking community long billions of $'s of non-performing debt.  

I wonder if the difference between the internal vs. external value of the $ is finally becoming an issue. It would appear, from, inter alia, recent inflation data that the internal value of the $ is declining.  However, a high external value of the $ hurts, among other bodies, countries with external $ denominated debt.  Additionally, and perhaps more crucially to the eventual recovery, the strong $ exchange rate makes the US production side of the economy less profitable, which explains recent cries for help from the NAM (National Association of Manufacturers).   

The graphs below illustrate this point using US Auto Production as a proxy for Manufacturing in general.  The contrast between the Fed easing campaign of 1998 coupled with a US$ decline and the current much more aggressive easing campaign absent a US$ decline is, in my view, stark. 

Note the lack of employment gains despite easing of 275bps relative to the 75bps in 1998.

To the extent that sustainable employment correlates with profitable production, I argue that the current policy which, in effect, if not by design, widens the gap between the external and internal values of the US$, is doomed to failure.  To the extent that the, now quite synchronized global economy, hinges on the continued willingness and ability of the ubiquitous US consumer to do his thing, both of which depends upon continued employment, current trends do not bode well.  

I would call this situation a catch-22, in that the policy response needed to restore growth may very well lead to a severe equity market dislocation and yet, absent the appropriate policy response, the real sector will not perform to the expectations built into equity market valuations.  Instead the gap between those expectations and reality will only widen, in some relationship to the divergence between the internal and external values of the $.   To my mind, the situation is unsustainable.  Yet, to cure the world of its bi-polar $ disease, either US interest rates rise, justifying the exchange rate or the exchange rate falls, matching the interest rates, a catch-22 all around.

Happy Trading.

** Data Source  CEIC