Dollar rises, but what about economy?

The dollar has bottomed, said excited analysts at Goldman Sachs on Thursday. The investment bank's Thomas Stolper said the "underlying picture" had turned "much more dollar positive" as he revised upwards his year-end forecasts for the greenback versus the euro, sterling and the yen.

Sure enough, the dollar rallied last week. A sharp, shocking, rampaging rally showed the sudden slump in the value of the pound against the American currency.

So, you might be wondering, what seismic piece of news did you miss?

Good question. The short answer is that you didn't.

What happened is that financial markets got confirmation of something that has been pretty obvious for many months – that the rest of the world has not 'de-coupled' from the American economy. A sharp slowdown in the US leads, inevitably, to a slowdown across the globe. Bald statistics from the European Central Bank and a gloomy prognosis from the Bank of England were seized upon by many in the financial markets as a signal to move out of commodities and emerging market currencies, which in itself was enough to give a huge boost to the dollar.

Is this logical? On one level, yes. Energy and metals have had such an extraordinary couple of years a point was always going to be reached when it made sense to reverse the bet. In market parlance, energy has been 'overbought', and financials 'oversold' to extremes never before seen.

But what would be a mistake would be to assume that this supposedly turning point for the dollar is evidence that the US economy itself is on the mend.

Consider these points, which were being circulated on a private basis by one London-based strategist at the end of last week.

The US housing sector represents the spine of the average American personal household balance sheet. Indeed, almost half of the $22 trillion of US household assets are held this way.

Yet Case Shiller, the pre-eminent authority on US housing, reckon house prices in the US need to fall by at least another 10 per cent for the market to 'normalise'. And yet foreclosures were up 53 per cent in June, year on year, repossessions tripled and over half of all loans to sub-prime borrowers were revealed to be in negative equity.

The recent growth in US economic output was fuelled almost exclusively by the growth in US exports. But a rising dollar will crimp those exports. And there's this little matter of America's prime trading partners not being able to afford as many American goods as they once did. Remember that Europe, which is slowing fast, is five times the economic size of China. Japan, the world's second largest economy, is on the verge of recession. Asian growth is slowing across the board and in China, which ranks as the second largest trading counter party to the US, real GDP growth has slowed for four consecutive quarters.

There are a host of other indicators that should be taken as a warning. The Baltic freight index, consider by many to be a good proxy for global trade, has fallen 40 per cent from its peak.

The Federal Reserve has voiced its opinion that a recession can be avoided in the US. But its forecasting record has not been good of late and this optimism flies in the faces of just about every economic survey. Add to that the fact that, historically, stock markets have never bottomed right at the start of a recession, and all of a sudden the bounce in prices we have seen over recent weeks begins to look like what is commonly called a "bear market rally."

We've watched, mesmerised, at the impact of the credit crisis on structured finance and other trading assets. What we are now likely to witness – in the West especially – is something much more prosaic: rising bankruptcies, rising unemployment, falling corporate earnings and an increase in insolvencies.

And then there's the banks. If it were true that some big investors are switching from over-bought energy assets to over-sold financials, then the following would seem to be relevant.

So far there have been around $300bn in write-offs by the main banks in the US and across Europe. But the OECD told us some time back that the number would rise to $500bn, while the IMF suggested $1trn would be a more accurate figure. Accounting changes in the pipeline will also bring billions more in off-balance sheet financing back on to the banks' books, exacerbating the capital problems.

What this all adds up to is forced de-leveraging – and, given the extremes of debt built up during the boom, that is a process that will take years not months. Consider, for example, that the US debt/GDP ratio is still close to 350 per cent; ahead of the Great Depression it got to 270 per cent.

As for the wider corporate sector, ratings agency Moody's recently predicted that the global default rate, which hit 2.5 per cent in July against two per cent in May, will rise to 6.3 per cent by next July and could conceivably jump to 10 per cent. In the US, corporate defaults are still running at less than one per cent. That looks odd – and unsustainable – when the average of the past 30 years stands at close to 4 per cent.

In terms of profitability, the average fall in earnings amongst S&P 500 companies for the second quarter is running at minus 22 per cent, compared with a fall of 16.2 per cent in the first quarter of the year. That second quarter decline will be the fourth consecutive quarterly fall – and yet Wall Street optimistic sector analysts are forecasting a consensus bounce of plus 2/1 per cent for the third quarter of this year.

Is that really a credible prediction? This correspondent, for one, thinks not.

The dollar may well have bottomed – globally and in relative terms. But don't see that as a sign that economic conditions are finally on the mend.

-- The author is Associate Editor of the Financial Times