U.S. Corporations Hurt by Currency Fluctuations

U.S. corporations are beginning to complain about the damage that the strong dollar is having on corporate earnings. This morning, United Technologies announced plans to lay off 11,600 workers as a rising dollar and deteriorating economic conditions forces the company to reduce costs. Yesterday, McDonald’s warned that the strength of the dollar and respective weakness in other currencies could decrease first quarter revenue by at least $600 million and earnings by 7 to 9 cents a share. Last week, Burger King Corp and Estee Lauder also announced that their profits dropped as international sales translated into fewer dollars.

A strong dollar is both good and bad, but the bad outweighs on the good especially in the current day and age when U.S. corporations are doing a lot of business abroad.

The impact of currencies on earnings is something we have discussed often on this blog. Imagine that McDonald’s sells Big Macs in the U.K. for 2 British pounds at a GBP/USD exchange rate of 1.80. For U.S. based McDonald’s, that would mean revenue of $3.60 per Big Mac. Suppose that the British pound weakens 20 percent, bringing the GBP/USD exchange rate down to 1.44. The 2 British pounds that they charge for each Big Mac now equals revenue of only $2.88 instead of $3.60. Compound this by millions of Big Macs sold abroad and you understand how a strong dollar hurts companies like McDonald’s.

U.S. Needs a Weak Currency

What the U.S. economy really needs is a weak currency because it will keep demand domestic and help increase the profitability of U.S. corporations doing business abroad. Unfortunately until fear and uncertainty about the financial sector subsides that may not happen anytime soon. In the interim, it is important to realize that the recent strength of the U.S. dollar will contribute to the difficulties plaguing U.S. corporations and because of that, first quarter earnings could take a bigger hit than most investors would expect.

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Fed Announcement Triggers Dollar Rally

The Federal Reserve has officially run out of room to cut interest rates. For the first time since August 2007, they left interest rates unchanged at a target range of 0 to 0.25 percent.

The dollar rallied because the Fed did the minimum of what was needed to pacify the market, which was to say that they could purchases Treasuries but are not going to do so right now.

Currency traders were looking for something more radical such as inflation targeting or a bold announcement that they start buying long term Treasuries in size – which would have been dollar bearish. Interest rates could remain at current levels for the next six months as the central bank focuses on credit easing.

The Federal Reserve was pessimistic about the outlook for the US economy and said that inflation could continue to remain weak in the coming quarters.

In the long run, the Fed’s lack of commitment is still….

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Bernanke Rebrands Quantitative Easing as Credit Easing

For the first time since cutting interest rates to 0.25 percent, Federal Reserve Chairman Ben Bernanke outlined his plan of action. In a speech at the London School of Economics, Bernanke talked about the additional tools available to the Fed, an orderly exit strategy, concerns about inflation and suggestions about how the Obama Administration should use the remainder of the TARP funds.

What is the Difference Between Credit and Quantitative Easing?

Most importantly, Bernanke created a new name for his regime – credit easing. In contrast to Quantitative Easing, which Bernanke explains focuses on the liabilities portion of the central bank’s balance sheet, Credit Easing focuses on expanding the asset side of the balance sheet. However since the balance sheet is suppose to balance, this may just be a difference of semantics since both efforts ultimately add liquidity into the financial system. The Federal Reserve wants to draw a distinction between their current policies and the Bank of Japan’s policies between 2001 and 2006.

The Fed’s Toolbox

As for the tools that they have at their disposal, there was nothing groundbreaking. Their number one tool is policy communication, followed by liquidity facilities for banks, facilities for other markets and purchases of long term securities. Like Federal Reserve President Lockhart, Bernanke expects interest rates to remain low for an extended period of time.

Inflation Concerns and Exit Strategy

As we expected, inflation is not a concern because the Fed believes that weaker growth will keep inflation low. In terms of an exit strategy, he expects demand for the emergency facilities to wane as the US economy improves.

Use of TARP Funds
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US Dollar Forecast: What’s In Store for 2009?

2008 Price Action: It has been an exceptionally active year in the foreign exchange market as currency volatilities hit record highs. In the first half of the year, everyone was worried about how much further the dollar would fall but in the second half of the year the concern became how much further the dollar would rise. More specifically, after hitting a record low against the Euro in the second quarter, the US dollar surged to a 2 year high against the currency in the beginning of the fourth quarter. From trough to peak, the dollar index rose more than 23 percent in 2008.

3 Themes for 2009: The US economy and the dollar’s fate in the years ahead could be determined by what happens in 2009. We are focusing on 3 big themes that will impact the US dollar and each of these themes encompasses a lot.

1. U or L Shaped Recovery: The US is in recession and the slowdown is expected to deepen in 2009. Before a recovery is even possible, the economy has to work through more weakness and negative surprises. Non-farm payrolls declined by 533k in November, sending the unemployment rate to a 15 year high of 6.7 percent. With many US corporations forced to tighten their belts, the unemployment rate could rise as high as 8 percent. We expect this to happen because over the past 50 years on average, recessions have boosted the unemployment rate by 2.8 percent. When the current recession started in December, the unemployment rate was 5.0 percent. If you tack on 2.8 percent, that would drive the unemployment rate to at least 7.8 percent.

Therefore non-farm payrolls could double dip, just as it has in past recessions. In this case, we would expect a rebound followed by another sharp loss that rivals November’s job cuts. A rise in unemployment spreads into incomes, spending and then usually leads to more layoffs. We need to see this toxic cycle end before we can see a recovery. Consumer spending has already been very weak and the trade deficit is widening as the dollar strengthens. As the 2 primary inputs into GDP, we expect fourth quarter growth to be very weak. The strength of the US dollar in Q3 and for most of Q4 will also take a big bite out of corporate earnings, leading to disappointments for the stock market. This is why we expect more weakness in the US dollar and the US economy in the first quarter of 2009. However towards the middle of the second quarter, we may begin to see the US economy stabilize as it starts to reap the benefits of Quantitative Easing and President Barack Obama’s fiscal stimulus plan. New Administrations usually hit the ground running and as such we fully expect the rest of the TARP funds to be tapped shortly after his inauguration. The shape of the US recovery will have a big impact on the price action of the US dollar and the path to a stronger dollar will be through a weaker one.

The following chart illustrates the double-dip trend of non-farm payrolls during the 2001 recession.

2. Safety vs. Yield: The dollar’s rally in the second half of 2008 has been largely driven by risk aversion, deleveraging and repatriation. In other words, despite the next to nothing yield offered by dollar denominated investments, a flight safety into US dollars and government bonds has kept the US dollar from collapsing against
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Retail Sales and PPI Still Stink

US retail sales and producer prices were basically in line with expectations but that does not undermine the fact that the data was very weak and confirms that the Federal Reserve will be cutting interest rates by 75bp next week. USD/JPY hit a 13 year low last night after news that the automaker bailout plan is not going happen before the new year. Everyone had hoped that the automaker saga would come to an end, but lawmakers are not letting that happen. On Wednesday, I said that USD/JPY could hit to a new 13 year. At that time, the currency pair was trading at 92.50-93.00. The possibility of the US taking interest rates below Japanese levels should keep the US dollar soft going into the Fed interest rate decision on Tuesday.

Consumer spending fell for the fifth month in a row while producer prices dropped for the second straight month. The two biggest inputs into GDP are retail sales and trade. Consumers cut back spending more aggressively in October and November which suggests that GDP growth could take a big dive in the fourth quarter, especially with the widening of the trade deficit.

GDP Could Contract by 4 to 6% in Q4

GDP could decline as much as 4 to 6 percent in Q4, which would be the largest contraction in growth since the 1980s. In the first quarter of 1982, GDP fell -6.4 percent. A 4 to 6 percent drop in GDP would not be out of the ordinary given the current conditions in the US economy. In the fourth quarter of 1990, GDP contracted by 3 percent and in the first quarter of 1991, it contracted by 2 percent. The currrent recession is worse than the one the US economy experienced in the 1990s, so a contraction in growth exceeding 3 percent would actually be expected.

The biggest drop in consumer spending came from gasoline station receipts. Prices at the pump have fallen more than 50 percent since the summer and gas stations are suffering as a result. The only silver lining in the retail sales report is the fact that not every sector saw slower sales. Electronics and sporting goods were in demand but this rebound after at least 4 consecutive months of softer spending is probably related to Black Friday sales.

BTW: EUR/GBP is at the brink of hitting 90 cents – a move that I called on Dec 8

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