Bottom Line: What's 'up' at Treasury?

WASHINGTON, May 22 (UPI) -- Now John Snow knows how Alan Greenspan feels.

In recent days, the Treasury secretary attempted to re-define, or at least re-explain, what the United States means by "a strong dollar." Investors, politicians, and journalists scrambled to figure out what he was trying to say; one reporter has even performed a "body language" analysis of the angle of the Treasury secretary's eyebrow as he says, "strong," and the movement of his hand when pronouncing the word, "deflation." Like his friend the Fed Chairman, Snow's every word will be surgically dissected, and will, in some cases, send financial markets plunging -- or soaring.

Treasury and White House officials say there is a method to the seeming chaos, which may put events in perspective. For investors, the short-term implication is, short U.S. markets, short the dollar. Over the longer term -- if and as the policy plays out -- long both. In the middle, long European Treasuries.

The United States, these officials say, is attempting to raise pressure on the European Union to lower interest rates. Snow made good progress in encouraging this objective, and surprising progress with the Germans, over the weekend. Then he tried to reinforce the progress by speaking blandly -- when asked -- about dollar "strength."

Snow's comments over the weekend, although clumsy in their delivery and last week's remarks about trade balances, were aimed at conveying an impression the United States would not be frantic to see further dollar declines, within reason. The goal is to persuade Europe to get out in front, reduce its own rates, and thus take up the burden of monetary expansion from the United States, which at 1.25 percent is "low on bullets."

Japan doesn't need to be lobbied. Tokyo won't allow the yen to rise more than another 2-3 percent anyway before intervening more strongly. China is a larger problem, given that the won should be strengthening, but China won't allow that.

The United States has few levers to encourage this directly, but feels it can encourage the same development indirectly through European rate cuts.

All roads to fighting "deflation" (which it's hard to see, in dollar terms) and slow growth (which it's easy to see) in the United States, then, seem to lead through Brussels and Berlin.

When Larry Kudlow, the TV economist widely and correctly perceived as an administration spokesman and trial-balloon artist, urged the Fed into a further rate cut in recent days, "he was not speaking for us," a Treasury source commented, with firm emphasis on "not." Another administration source adds: "Larry's freelancing on that one."

The White House view on further Fed rate cuts, according to these officials, is, "not necessary." This was implied by Snow's previous comments of early last week that deflation is not a danger.

As the tax bill moves to passage and the United States and world turn their attention to world problems, Snow wants to be another Jim Baker -- to revive a meaningful G7 coordination process in the brave new world of the EU and (note) of China's growing role in world monetary affairs. This is good news, over time. He's off to a rough start, partly because his international team and experience are weak, but partly because he lacks the conditions Baker enjoyed in the mid-1980s.

As you may recall, in the run-up to Baker's Plaza Accord, trade protectionist measures in Congress were gaining steam and the dollar was surging, making the point in events that Snow tried to make in words about the consequences to Europe of dollar strength and weakness.

Snow doesn't have Dick Gephardt scaring the dickens out of Europe, and the dollar has been weak, not strong, so he tried to raise some of those forces himself, or at least, suggest an opening. As he's now learned, gentle attempts to get the attention of Europeans and the markets generally don't work -- either they're too gentle and no one notices, or you raise too many concerns, as appears to have happened here.

In any case, the effort to lobby Europe, as Taylor admitted in a recent meeting, "needs work." It amounts to a giant game of chicken. Sometimes you can win at chicken, sometimes everyone loses -- but in any case, the game is bound to be unsettling in the short term.

Over that short term, as well, Snow must proceed in an environment in which his first significant foray into international monetary affairs is perceived as problematic.

And, in that same short term -- the coming 2-3 months -- futures markets are discounting a near-100 percent possibility of a further rate cut by the Fed. Such a cut would "only" be by 0.25 percent. Yet as our friend John Mueller has pointed out, this amounts to a 20-percent reduction in the short term rate, i.e. 0.25/1.25 = 20 percent. It's the same, in that sense, as cutting to an 8 percent rate from a 10 percent rate. The mere fact that this might happen is somewhat of a drag on investment-sensitive decisions to invest, refinance homes and even employ labor.

Finally, while this certainly might weaken the dollar more -- we are using that term in the good old fashioned sense that the dollar would buy fewer yen, euros, ounces of gold, tons of copper, and so on -- it puts Greenspan at odds, in practical terms, with Snow's (correct) objective of getting Europe to be the monetary expander from her on out. To "outdo" U.S. rate cuts, Europe would have to slash its rates by a full point or more.

As well, there's a possibility that having been burned in his first effort, Snow will simply shrink from trying to be a meaningful voice in monetary affairs. In that sense, Greenspan's testimony today -- firmly sticking with the line that the Treasury secretary, not the Fed chairman, is the spokesman on the dollar -- is a very good sign.

From our view, Snow has the right objective (European rate cuts) in mind, and a strong relationship with Greenspan, and improving one with the Europeans, to carry it out. But it's going to be messy for a time. A review of the press on Baker's international dollar diplomacy shows a decidedly negative tone -- until he succeeded.

In the meantime, we re-established our short position on U.S. equities as a hedge against world equity declines, late last week, and expanded it at 9:31 Monday following the hubbub over the weekend's dollar jawboning.

What will it take to make us bullish again? We'll probably keep the position on through an expected Fed rate cut and the months that follow, and take it off in the event of a significant European rate cut to help, not so much the dollar, but Europe's own stagnant and mildly deflating economy. Or -- which is still possible -- if the Fed holds its nerve, and leaves rates unchanged, or moves them up 1/64 of a point, in the weeks to come.

We'll be bullish again, as Snow's dollar diplomacy matures. This may take days, weeks, or months. Meantime we're short.

With respect.

(Gregory Fossedal is chief investment officer of the Democratic Century Fund, managed by the Emerging Markets Group. His firm may hold some of the securities mentioned in his articles. Individual investors should contact their own professional adviser before making any decision to buy or sell these or any securities.)