NEW YORK (Reuters)- A U.S. recession may be just what the U.S. dollar needs to trigger arebound, after a long slide in the past year or more, if historicaltrends hold true.
That may sound counterintuitive but in the past when the outlook forthe economy was at its worst and interest rates were at a low, thedollar has typically already begun to rally.
"A U.S. recession is a positive for the dollar in the sense thatexpectations bottom with respect to the U.S. growth outlook and U.S.interest rates eventually bottom," said Michael Woolfolk, seniorcurrency strategist at Bank of New York Mellon in New York.
"Expectations for strong U.S. growth and higher U.S. rates providesupport for the greenback as trade and investment flows providefundamental underpinning for a dollar rally," Woolfolk said.
Though the definition of recession can vary, during the acknowledgedU.S. economic downturn of late 2000 into 2001 the New York Board ofTrade’s dollar index .DXY peaked in July 2001 at around 121.
By then the Federal Reserve had already cut the benchmark overnightinterbank lending rate from 6.5 percent in May 2000 to 3.75 percent inMay 2001.
While the conventional thinking is that lower interest rates reducethe attractiveness of dollar-denominated securities the dollar onlybegan to fall from that peak as the Fed continued to cut rates to a40-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 beengrowing from the third quarter of 2001.
But by May 2004, the dollar index had recovered to around 92, withthe gain all prior to the Fed beginning a monetary policy tighteningcycle which lasted from June 2004 until June 2006.
In fact, in four of the past five US economic recessions going backto the early 1970s, the dollar has been higher four months after thedownturn ended than it had been four months before it began. In the oneexception, the 1990-91 recession, the greenback was essentiallyunchanged 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 indexwould not put in a bottom until the recovery were clearly back ontrack," 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 relativeto those elsewhere in the industrialized world will also play theirpart, Woolfolk places the potential for the dollar to begin to recoveracross the board no sooner than year end.
Joseph Quinlan, chief market strategist at Bank of America’s GlobalWealth & Investment Management in New York agrees with Woolfolkthat a U.S. recession will signal a dollar recovery but places thatrecovery closer in time.
"Sometime in the second quarter, the markets may come to believethat the U.S. economy will be the "first-in, first-out" in terms ofrecession/global economic slowdown, suggesting higher U.S. interestrates down the road," said Quinlan. "That is bullish for the buck."
The Federal Reserve has cut the benchmark rate by 300 basis pointsto 2.25 percent in the easing cycle that began last September withinvestors still debating whether the rate will be below 2 percent whenthe cycle ends.
Part of the problem in predicting when the dollar will recover isthat most "buy" signals will only be apparent after the recession isover, said Dustin Reid, senior currency strategist at ABN AMRO inChicago.
"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 signalas could large fund flows into the dollar, Reid said, but since mostdata is not real time, most signals are after the fact.
Looking at recessions since 1974, Marco Spaltro, London-basedcurrency economist at IDEAglobal, said "the market has alreadydiscounted the possibility of a recession in the U.S., and we are closeto a buy signal for the dollar."
That’s despite no contraction in the U.S. economy since the thirdquarter of 2001 and the economy still eking out a 0.6 percent gain inthe fourth quarter of 2007.
All of which may lead investors to conclude that the only sure betis when the recession is clearly in the past, and it is equally clearthe dollar is on an upswing.
(Reporting by Nick Olivari)
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