Yesterday, U.S. President George W. Bush named Paulson, a 60-year-old Wall Street veteran, to succeed John Snow, a former railroad executive who has led the department since February 2003. Hank Paulson’s nomination as Treasury Secretary may provide some temporary relief for the sliding USD owing to Paulson’s prominent status as a former of a top Wall Street firm. But we doubt that Paulson’s role at the Treasury in the next 2 ½ years will alter the current and emerging fundamental challenges to the US currency.

Considering Paulson’s Wall Street experience and credibility, we regard his appointment more of a defensive measure to prevent the dollar’s downtrend from accelerating into an uncontrollable pace, considering the endogenous and exogenous factors starting to weigh on the US currency (see below). Similarly, the Paulson choice should also prevent the already sliding stock market from succumbing to further pressures—pre-midterm election uncertainty, risk of renewed policy tightening by the Fed and an expected decline in US growth (we expect Q2 GDP growth to slow to 2.5-2.7%).

Just as the Bernanke Fed is conscious of the dollar repercussions of communicating an explicit conclusion to the 2-year old policy tightening campaign, the US administration has grown conscious of the market realities acting against the US dollar, leaving it no choice but to resort to a figure of credibility. This is not to say that the US Administration will pursue a strong dollar policy in both practice and preach as was under the Clinton-Rubin-Summers years, but will instead aim at pursuing a competitive currency without lacking in confidence.

The general rationale has been for Secretaries with considerable experience in Wall Street have supported or served during a period of a strong dollar, which is in line with shoring up foreign interest in US assets. Treasury secretaries emerging from an industrial background or those with considerable policy experience have generally preferred a weaker dollar so as to boost the priorities of local industry and employment.

Considering Paulson’s international experience, his selection also reflects the White House increased prioritization to international finance considerations (pressing on China FX revaluation before the midterm elections, working with G7 on imbalances) rather than on domestic policies (failed pension privatization, passed tax cuts), a Secretary with an international pedigree would be essential.

All in all, Paulson’s role is unlikely to reverse the current and incoming currents acting against the dollar. These are:

1. The inevitable tightening from the Bank of Japan—seen as triggering further unwinding of carry trade plays from low yielding currencies;

2. Central bank diversification from away from the dollar into euros or (and) gold, as has been the case with central banks in the Middle East, Sweden and recent indications from Russia to fortify the pricing in rubles across its economy, away from dollars and euros;

3. The US trade deficit may have shown signs of stabilization, but not sufficient to assure worries of reduced interest in US assets. In March, net foreign purchases of US treasuries plummeted 86% to 3-year low of $3.1 bln amid a broad decline in demand from both official and private accounts. In addition, foreign central banks were net sellers of US treasuries for the first time in a year at $6.3 bln. Slowing US demand may reduce import growth and help stabilize the trade current account deficit, but that is unlikely to slow the necessary import of petroleum, especially as the share of these imports accounts for 14% of total imports, up from 6% 4 years ago;

4. The Bank of England’s assertiveness to raise interest rates (expected as early as June) will be the element on which sterling bulls should fall back, especially after the remarkable shift of hawkishness in the BoE’s Monetary Policy Committee;

5. Our forecast for stability in metals and emerging markets, followed by renewed bounce—all induce further dollar losses;

6. The absence of FX jawboning from the ECB coupled with the required (and expected) policy tightening. Unlike in Jan 2004 when Trichet called euro rise “brutal”, the ECB is in the midst of a growth and oil driven commitment to fight a more serious inflation threat than in Q1 2004;

7. Increased signs of a slowdown in the US economy will create fresh reasons to sell the US dollar. In addition to the looming end of the Fed’s rate hikes, the shedding of the US growth story is likely to convince dollar bulls that the situation is more than just “deteriorating sentiment” and hits at the core fundamentals of the currency.

SOURCE: MG Financial

JON’S COMMENT
What a great article that points out a lot of the problems plaguing the US dollar since a few months. Unfortunately, I don’t think the new Treasury Secretary will be able to drastically make changes which could save the downward spiral the US dollar has entered and which I believe will accelerate in the coming months as well.