A Recession May Bode Well for the Dollar

By Reuters -  |  Posted 2008-04-09 Email Print this article Print

History shows that a recession has helped the dollar.  

NEW YORK (Reuters) - A U.S. recession may be just what the U.S. dollar needs to trigger a rebound, after a long slide in the past year or more, if historical trends hold true.

That may sound counterintuitive but in the past when the outlook for the economy was at its worst and interest rates were at a low, the dollar has typically already begun to rally.

"A U.S. recession is a positive for the dollar in the sense that expectations bottom with respect to the U.S. growth outlook and U.S. interest rates eventually bottom," said Michael Woolfolk, senior currency strategist at Bank of New York Mellon in New York.

"Expectations for strong U.S. growth and higher U.S. rates provide support for the greenback as trade and investment flows provide fundamental underpinning for a dollar rally," Woolfolk said.

Though the definition of recession can vary, during the acknowledged U.S. economic downturn of late 2000 into 2001 the New York Board of Trade's dollar index .DXY peaked in July 2001 at around 121.

By then the Federal Reserve had already cut the benchmark overnight interbank lending rate from 6.5 percent in May 2000 to 3.75 percent in May 2001.

While the conventional thinking is that lower interest rates reduce the attractiveness of dollar-denominated securities the dollar only began to fall from that peak as the Fed continued to cut rates to a 40-year low of 1.0 percent in June 2003.

That helped send the dollar index .DXY to around 85 in early 2004, according to Reuters data, even though the U.S. economy had been growing from the third quarter of 2001.

But by May 2004, the dollar index had recovered to around 92, with the gain all prior to the Fed beginning a monetary policy tightening cycle which lasted from June 2004 until June 2006.

In fact, in four of the past five US economic recessions going back to the early 1970s, the dollar has been higher four months after the downturn ended than it had been four months before it began. In the one exception, the 1990-91 recession, the greenback was essentially unchanged over such a span.

What does that mean for the U.S. dollar in 2008?

"Were the dollar to follow the example of 2002-04, the dollar index would not put in a bottom until the recovery were clearly back on track," said Bank of New York Mellon's Woolfolk.

So the sooner the recession is over, the sooner dollar investors can enjoy a sustained rally.

Though there are multiple variables at play and U.S. rates relative to those elsewhere in the industrialized world will also play their part, Woolfolk places the potential for the dollar to begin to recover across the board no sooner than year end.

Joseph Quinlan, chief market strategist at Bank of America's Global Wealth & Investment Management in New York agrees with Woolfolk that a U.S. recession will signal a dollar recovery but places that recovery closer in time.

"Sometime in the second quarter, the markets may come to believe that the U.S. economy will be the "first-in, first-out" in terms of recession/global economic slowdown, suggesting higher U.S. interest rates down the road," said Quinlan. "That is bullish for the buck."

The Federal Reserve has cut the benchmark rate by 300 basis points to 2.25 percent in the easing cycle that began last September with investors still debating whether the rate will be below 2 percent when the cycle ends.

Part of the problem in predicting when the dollar will recover is that most "buy" signals will only be apparent after the recession is over, said Dustin Reid, senior currency strategist at ABN AMRO in Chicago.

"There is not ever a clear signal," Reid said. "Every macro-economic cycle is different."

The Federal Reserve shifting to a neutral stance could be a signal as could large fund flows into the dollar, Reid said, but since most data is not real time, most signals are after the fact.

Looking at recessions since 1974, Marco Spaltro, London-based currency economist at IDEAglobal, said "the market has already discounted the possibility of a recession in the U.S., and we are close to a buy signal for the dollar."

That's despite no contraction in the U.S. economy since the third quarter of 2001 and the economy still eking out a 0.6 percent gain in the fourth quarter of 2007.

All of which may lead investors to conclude that the only sure bet is when the recession is clearly in the past, and it is equally clear the dollar is on an upswing.

(Reporting by Nick Olivari)


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