By Kathy Lein .. So far, it has been a great year for… … the dollar. The greenback has increased 12% in value against the euro since January, 5% against
the Japanese Yen and 7% against the British Pound. Higher US interest rates, improvements in the manufacturing sector and average monthly gains of 190k in payrolls has helped the dollar charge full steam ahead. However, since July, there have been signs that the dollar may have hit a peak with double threats plaguing the greenback and even more risks in the pipeline. The rally in oil shows no signs of giving way, even though we are making new record highs on a near daily basis. With oil prices at $66 a barrel, $80 now seems
to be a more realistic target than $40. The housing market is also showing signs of exhaustion and if the housing market goes, so does the US consumer. Oil and housing hold the key to the dollar’s fate in many ways including being able to affect the Federal Reserve’s monetary policy decisions.

Oil Prices – $100 a Barrel Can Cripple US Growth economy and the US dollar faces big risks in the months ahead. Right now, US consumers have been somewhat shielded from needing to really deal with the high cost of oil by carpooling or using mass transit. However once the weather turns cooler, consumers will not be able to avoid turning on their heaters. Although not all Americans use oil to heat their homes, natural gas, which is the most popular source of fuel, has prices that are also at record highs. Therefore, even though consumer spending has yet to contract significantly, it could towards the end of the year if oil stays at current levels. Right now consumers are treating the rise in oil as
temporary and have continued to spend, borrowing more and even dipping into household wealth. Yet with this oil shock being a demand based problem rather than a supply-based problem, there is no abnormal factor such as weather or geopolitically uncertainly that can later be corrected to term this a temporary phenomenon. With Indian and Chinese consumption driving the demand and their consumptions needs expected to increase even further over the next few years, the 2-year increase in oil prices that we have seen thus far could be far from temporary. Nine out of the last ten recessions have been associated with rising oil prices and even though we don’t expect a recession again, we do expect a sharp contraction in growth, which could spell disaster for the US dollar.

The other big risk to the US economy is the real estate market. When you have TV shows called “Flip this House” on A&E and its competitor “Flip that House” on the Discovery Network, touting how easy it is to make fast profits in real estate, you know that the market is in trouble. In fact this feels like the dotcom boom deja vu all over again with real estate now seen as the new form of “paper” wealth. Since 2001, real estate has accounted for 70% of the rise in net household worth. Typically the housing market represents just 5% of the total economy, but according to Merrill Lynch, the housing market “accounted for an astounding 50% of the overall growth in the U.S. economy by the first half of this year, and more than half of the private payroll jobs created since fall 2001 were in housing related sectors.” With investors flipping real estate like short-term stock market investments, it has really become a speculator’s market. For sale signs can be found on nearly every block in the states that are red on the USA Today map. Of course, people have been calling for a burst of the housing market bubble for years now and have only been proven wrong. Yet the mania is getting more and more dangerous with increasing evidence that the day of reckoning may be right around the corner. In Phoenix, Arizona, prices have increased 47% in the first quarter from a year ago. The highest median price for a home in the US has reached $726,00 in San Francisco. Inventories are building up across the country with the number of homes on sale in the market up 26% in northern Virginia, 31% in Massachusetts and doubling in San Diego from a year ago. With any product that is losing popularity, the first sign that it is in trouble is that it stays on the store shelves for a longer period of time and inventory just accumulates. The next logical step for the storeowner is to cut prices, hoping for a fire-sale. We are already seeing the first step unfolding in real estate, which is inventory buildup and properties spending a longer time on the market. Although we think that a substantial contraction in prices is far more likely than a crash, any sizeable slowdown in the market could spell disaster for US consumer spending, the US economy and the US dollar. In addition, it will certainly have ripple effects on the rest of the world. Conditions will only worsen for the US housing market and consumer spending as the Federal Reserve continues to raise interest rates. Mortgage costs in general will increase, but the hardest hit will be the people who hold adjustable rate mortgages. The same is true for other forms of credit that have a floating rate such as home-equity loans, car payments and credit card payments. Both of these factors can also play a big role in the fed’s monetary policy decision
The key to the dollar’ is oil and housing. Either of these factors alone could cause a sharp contraction in US economic growth, but the fact that both of these factors are unfolding as major risks at the same time exacerbates the uncertainty that the US economy faces in the second half of the year. The primary reason the dollar has been able to hold onto its gains is high interest rates and the prospect of higher interest rates to come. If consumer spending contracts significantly because of any one of these reasons, the Fed may be
forced to halt rate hikes sooner than they may have otherwise wanted, which could take away the dollar’s one ally. If oil prices retrace or if the housing market keeps on booming, then these concerns could fade to the sideline, keeping the dollar rally intact.

The Curse of the First Year

Interestingly, perhaps this is also the curse of the first year that the new Fed Chairman has to face. By the time all of this becomes a major issue, it may no longer be Greenspan’s problem. Greenspan is slated to leave office on January 31, 2006. Since 1970, every Fed Chairman that assumed the top job has faced a major crisis shortly after entering office. According to Toni Straka of Prudent Investor, “Arthur F. Burns, chairman from February 1, 1970, climbed the top chair only to oversee the beginning of the 1970's bear market, the closing of the gold window and the first oil shock in 1973. When he stepped down on August 6, 1979, his successor Paul A. Volcker had to fight double digit inflation with the highest Fed Funds rates seen ever and managed that the economic downturn through his tightening only became an on-and-off recession from 1979 to 1982 with GDP never declining more than a quarter in a row.” Greenspan himself had to deal with the stock market crash of 1987. Therefore it would come as no surprise if either oil and housing or both becomes the next Chairman’s initiation task. Even if the next Chairman is highly respected competent, we are sure that market
will be skeptical about whether he or she has what it takes to pull the economy of its slump and to come out of Greenspan’s shadow. Uncertainty and skepticism of policy or a major policy official is almost never good for a country’s currency.

Kathy Lien
Chief Strategist
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: klien@fxcm.com

The information contained herein is derived from sources we believe to be reliable, but of which we have not independently verified.
FXCM, L.L.C.® assumes no responsibility for errors, inaccuracies or omissions in these materials, nor shall it be liable for damages
arising out of any person’s reliance upon this information. FXCM, L.L.C.® does not warrant the accuracy or completeness of the
information, text, graphics, links or other items contained within these materials. FXCM, L.L.C.® shall not be liable for any special,
indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from
these materials. Opinions and estimates constitute our judgment and are subject to change without notice. Past performance is not
indicative of future results.