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Bottom Line: Strong-dollar polities

WASHINGTON, Jan. 14 (UPI) -- President Bush and his Treasury Secretary have redoubled their rhetoric about the administration's "continued strong dollar policy" in recent days, prompting one market-watcher here to quip, "I guess that means a $1.5 euro by April." But for once, it may be that politics is synchronizing with reality, and reality with markets, in a kind of rare planetary alignment.

"Bottom Line" went long the dollar against the euro prematurely in terms of timing, back in November, but (so far) accurately predicted the greenback wouldn't even fall to 1.4 to the euro, let alone 1.5. The likelier scenario is a dollar rebound (i.e. Euro decline) to the $1.2 range, or thereabouts, by as early as April.

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Conventional wisdom, hypnotized by U.S. trade and budget deficits and European Central Bank stubbornness, is still looking for continued dollar weakness into the spring. This is one reason the dollar is becoming a good investment.

If mere jawboning could do the trick, of course, then Secretary Snow's comments of 2002 and 2003 would have halted the greenback's decline at around 1.1 Euro. Earlier this week, major league baseball adopted much stricter limits on the use of steroids by its athletes. The Bush administration could use some of the surplus supply for the U.S. currency, which needs not just "no pain no gain" slogans, but real beef.

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"The beef" appears to be taking shape, in at least three ways.

The first is fundamentals. Estimates by both J.P. Morgan and Leherman Bell Mueller Cannon have the dollar at perhaps 15-20 percent undervaluation. The latter is a liquidity estimate based on U.S. dollar creation by the Fed and by foreign central banks. The former is a purchasing-power estimate, i.e., at today's exchange rate, adjusted for tax rates and other non-monetary factors, the same basket of goods costs more in the U.S. than Europe -- indicating the dollar should rise or the Euro fall.

To paraphrase Lord Keynes, one can go broke waiting for markets to return to rational levels. But the coincidence between price fundamentals and money-supply creation suggests at least a healthy foundation for Messrs. Bush and Snow (not to mention Greenspan) to build on, should they want to convert "strong dollar policy" into "strong dollar reality."

A second factor for dollar strength is U.S. military action in Iraq, and the broader geostrategic situation in places like South Asia and its Tsunami victims; South Korea and the treat of nuclear expansion to the North; and, of course, the U.S.-led occupation of Iraq, Afghanistan, and other states close to the Israeli-Palestinian standoff.

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In broad, general terms, overseas crises, and particularly those involving U.S. exercise of power, tend to promote a strong dollar -- provided America is successful. Everyone knows what a mess Iraq is. Everyone knows there will never be peace in the Middle East, real nuclear restraint by Pyongyang, and so on.

In fact, however, markets may be overdiscounting the likelihood of U.S. failure -- and underestimating the prospects for success. Elections of any sort in Palestine are a plus for Israel, and, to boot, last weekend's vote lifted to the presidency a former prime minister whom Ariel Sharon finds an acceptable negotiating partner.

Iraqi elections schedule for January 30 have -- as did elections in Afghanistan and Palestine -- brought about a surge of pre-voting violence. Few people have high expectations for the kind of success in oil-rich Iraq that was enjoyed in Afghanistan. What this means, however, is a potential for an upside surprise if even a respectable turnout and post-election calm can be achieved.

Markets are all about the future, and mostly about economic policy. Accordingly, the dollar's fate hinges, more than anything else, on U.S. monetary and fiscal policy.

On the monetary side, the Fed is providing only modest help. U.S. interest rates are still, essentially, zero in inflation-adjusted terms. But they're headed up, and may be edged up faster than in 2004, according to recent Fed minutes and statements.

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It's in the area of fiscal policy that events have changed most in recent days. President Bush has put Social Security reform ahead, even, of another tax cut. A Bush achievement here wouldn't have substantial impact on the near-term U.S. budget deficit. But in long-term political terms, it would be even more important. If Mr. Bush can achieve changes in Social Security, "he can do anything," in the words of one frightened Democratic Senatorial aide.

Mr. Snow and other Bush officials promise a discretionary domestic spending freeze. Even allowing that this will not include a reduction in massive war spending, and even allowing the usual fuzzy math that will probably take place in implementing the plan, it would be a large change from Mr. Bush's first term, which saw the greatest expansion in U.S. spending since Lyndon Johnson.

(And, yes, GOP soundbiters: This is true even if one makes the generous assumption that everything labelled "war on terror" is actually that, and thus subtracted from these estimates.)

A key sign of the administration's seriousness in the coming weeks will be its attitude on agriculture subsidies, which this administration rescued from what appeared to be a death bed in the late 1990s. Not that the savings that might be achieved there ($30 billion?) will, of themselves, turn the deficit around.

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Rather, agrisubsidies are a kind of political indicator. "If you can't cut those," as the late Robert Bartley once put it, "what can you cut?" Furthermore, many of the beneficiaries are blue-blood corporate and affluent-individual farmers in so-called red (Republican) states. A serious effort to phase down and even eliminate farm welfare in the secon term would demonstrate budget seriousness. Lack of same will suggest more emphasis on fiscal gimmicks.


The Bottom Line


Dollar strength, in this case, probably does not mean a broad-based deflation. Indeed, oil should enjoy continued strength in the $45 to $50 range, and gold challenge $500 again by summer.

Rather, the dollar should rally against the euro, both as the ECB capitulates to the cries of pain from exporters, and given the reluctance of the Chinese central bank to allow a rise against the dollar. The former is the hammer, the latter, which means a weak dollar also means a weak juan, the anvil. The euro is the pliable metal in between, likely to be reshaped to a more-sane level of 1.2.

Still long the dollar, and ready to increase the position in the event of a last-gasp decline to $1.37 or $1.38 to the euro.

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Gregory Fossedal is an advisor on emerging markets and geopolitical risk to international investors, and a research fellow at the Alexis de Tocqueville Institution. His clients may hold long and short positions in many of the investment securities and opportunities mentioned in his reports. Investors should perform their own due diligence and consult their own professional advisor before buying or selling any securities. Mr. Fossedal's opinions are entirely his own, and are not necessarily those of his clients, UPI, or AdTI. Furthermore, they are subject to change without notice.

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