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should we worry about the US$ exchange rate?

Thursday 26 April, 2007

Bill Barnhart

Inflation pushing U.S. dollar into foreign territory

Published April 18, 2007

The dollar reached a dubious milestone Tuesday, as a British pound bought more than $2 for the first time in nearly 15 years.

That means you’ll probably hear more British accents in downtown Chicago this summer. Combined with dollar weakness against the euro, it’s too bad for Chicago’s tourism industry that the Olympics won’t be staged here this year.

U.S. investors who hold international mutual funds can count themselves among the winners. Stronger foreign currencies buy more dollar-based investment returns. The iShares United Kingdom exchange-traded fund, for example, is up 7.4 percent this year, compared with a 4.2 percent gain for the iShares S&P 500 index.

 

mm comment: personally I think buying mutual funds based on currency plays is risky business. My preference would be to find a fund that fits what you’re seeking & if you can benefit from currency appreciation, all the better as a bonus.

 

Amid uniformly benign financial conditions around the world, traders seeking an edge accentuate every difference between investment factors. On Tuesday, the spotlight fell on inflation; in particular, on the inflation comparison between the United States and Great Britain.

Here, the Labor Department reported that so-called core inflation, not counting food and energy prices, eased last month from strong showings in January and February. On an annual basis, the U.S. consumer price index, including food and energy, is climbing at about a 2.8 percent rate, well below the 3.4 percent rate of a year ago.

Across the pond, the latest British inflation report shows a 3.1 percent rate, the steepest inflation there in 10 years. Inflation comparisons such as these help convince analysts that the Bank of England is more likely to raise interest rates than the U.S. Federal Reserve. Higher rates attract traders into a currency.

 

mm comment: Again, basing currency buys based on inflation, even core inflation, seems flawed. High inflation leads to higher interest rates, leads to higher borrowing costs, leads to less investment, which results in lower economic returns. Currencies are ultimately based on the performance of a whole economy, not just 1 of its components.

 

But it is easy to overstate comparisons of routine economic data, which can fluctuate day by day. International Monetary Fund statistics indicate that inflation is under control in all major countries.

Here are a few examples. Inflation in Australia declined to an estimated 2.8 percent this year from 4.5 percent in 2000. Inflation in Ireland eased to an estimated 2.4 percent this year from 5.2 percent in 2000. IMF forecasts for 2008 show inflation edging higher in several countries, including the United States, but there is no sign of serious inflation anywhere among the world’s major trading partners.

The persistent weakness of the dollar must reflect something else. John Brady, senior vice president at Man Financial, said the principal difference is economic growth.

“We are in a global deflationary environment, and because the U.S. imports so much, especially in terms of labor costs, the trend is being maintained,” he said.

Wage inflation is absent in most of the world, he said. On the other hand, “the tone and structure of European growth is impressive,” he said.

Brady said petrodollars from the Middle East are being recycled to Europe and Britain, not to the U.S.

“Some of that may be a political statement; some of it may not be,” he said. But “that explains the strength of their currencies and helps explain the differentials in interest rates.”

The money supply is booming in Europe, Brady said.

“You’re seeing a lot more investment going into Europe,” he said. “The European money supply figures have shown tremendous velocity.”

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