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Ambrose Evans-Pritchard: The race to the bottom has begun

Section: Daily Dispatches

Dollar Surge Will Not Stop America From Feeling Effects of Global Crunch

By Ambrose Evans-Pritchard
The Telegraph, London
Monday, August 18, 2008

Two alerts landed on my desk this weekend from the elite markets team at Goldman Sachs. One was entitled "The Dollar Has Bottomed!" Those betting on an imminent disintegration of American economic and political power may have to wait another cycle. Rival hegemons are falling like ninepins.

The US dollar index hit an all-time low in March. It crept slowly upwards in the early summer before smashing through layers of resistance over the past month.

The surge against sterling, the euro, the Swiss franc, and the Australian dollar is one of the most spectacular currency shifts in half a century. "Something fundamental has changed," said the bank. Indeed.

US industry is now super-competitive, if small. Mideast funds are drawing up shopping lists of Wall Street takeover targets. Airbus and Volkswagen are shifting plant to America to escape crushing labour costs.

US exports have risen 22 percent over the past year, outstripping Chinese growth. The US non-oil trade deficit has shrunk by two fifths since 2002. It is now running at $300 billion a year. This is 2.1 percent of GDP.

The other note advised clients to "Take Profit on Globalization Basket," especially on eastern European currencies. Goldman Sachs has quietly dropped its talk of $200 oil. Even Russia's petro-rouble is now deemed suspect.

The twin missives more or less sum up the dramatic change in mood sweeping financial markets since it became evident that the entire bloc of rich OECD countries has succumbed to the delayed effects of the credit crisis.

Japan contracted by 0.6 percent in the second quarter, Germany by 0.5 percent, France and Italy by 0.3 percent. Spain recalled the cabinet last week for an emergency summit. New Zealand and Denmark are in recession. Iceland contracted at a catastrophic 3.7 percent in the second quarter.

"The whole decoupling thesis has started to come apart at the seams," said David Bloom, currency chief at HSBC. "Canada is frozen over. We have Arctic conditions in Sweden, and the UK is falling off the white cliffs of Dover."

The UK economy is not my brief, but I see that hedge funds are circulating a report from the US guru Jeremy Grantham predicting a very bad end to Gordon Brown's debt experiment.

"The UK housing event is probably second only to the Japanese 1990 land bubble in the Real Estate Bubble Hall of Fame. UK house prices could easily decline 50 percent from the peak, and at that lower level they would still be higher than they were in 1997 as a multiple of income," he said.

"If prices go all the way back to trend, and history says that is extremely likely, then the UK financial system will need some serious bailouts and the global ripples will be substantial."

For months the exchange markets ignored this impending train crash, just as they ignored the property bust in Europe's Latin Bloc, or the little detail that UBS alone had just lost the equivalent of 8 percent of Switzerland's GDP. All they cared about in the currency pits was the interest rate gap: US low, Europe high.

Now the paradigm has flipped. The Fed may have been right after all to slash rates to 2 percent. The European Central Bank may have panicked by tightening in July. Note that the elder Swiss National Bank did not do anything so rash.

Bulls now believe America is turning the corner. Financial stocks are up 20 percent since early July. Some "monoline" bond insurers have risen 1,200 percent in a month as fears of Gotterdammerung give way to sheer intoxicating relief, and a "short squeeze." Such are bear-trap rallies.

Regrettably, I remain beset by gloom. The US fiscal stimulus package that kept spending afloat in the second quarter is running out fast. There is nothing yet to replace it. The export boom cannot keep adding juice as the global crunch hits. My fear is that the US will tip into a second, deeper leg of the downturn, setting off a wave of savage job cuts. This will start to feel more like a real depression.

The futures market is pricing a 33 percent fall in US house prices from peak to trough, based on the Case-Shiller index. Banks have not come close to writing off implied losses on this scale.

Daniel Alpert from Westwood Capital predicts that a mere 28 percent fall would alone lead to a $5.4 trillion haircut in US household wealth, and leave lenders nursing $1.25 trillion in losses. So far they have confessed to less than $500 billion.

Meredith Whitney, the Oppenheimer's bank Cassandra, predicts a gruesome 40 percent fall in prices. If so, expect prime borrowers facing negative equity to start throwing in the towel en masse. "I do not think we are near the end of writedowns. I continue to see capital levels going lower, and stocks going lower," she said.

So no, this painful ordeal is far from over. We are not witnessing a dollar rally so much as a collapse in European and commodity currencies. The race to the bottom has begun in earnest.

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