Economic Overview

The US is the world's leading economic power, with GDP valued at over US$10Trl in 2001. This is the highest in the world and based upon PPP, it is 3 times the size of Japan's output, 5 times the size of Germany's and 7 times the size of the UK's. With the US having the most liquid equity and fixed income markets in the world, foreign investors have consistently increased their purchases of US assets. Foreign direct investments represent approximately 40% of total global net inflows for US. On a net basis, the US absorbs 71% of total foreign savings.

The import and export volume of the US also exceeds that of any other country. On a netted basis, the US is running a very large trade deficit of nearly $500bln. This is because the US is the largest trading partner for most countries, representing 20% of total world trade.

This large absolute number indicates that the US is heavily reliant on capital flows and the dollar is very sensitive to changes in those flows. In fact, in order to prevent a further decline in the USD as a result of trade, the US would need to attract close to $1.9bn in capital inflows per day.

The US is primarily a service-oriented country with nearly 80% of their GDP coming from real estate, transportation, finance, healthcare, and business services. With the advent of new technology such as the internet, productivity in the US has consistently increased. This is particularly interesting in light of the US's recent economic downturn, because many economists argue that despite the current downturn, increased productivity indicates that we are in a "new economy." The importance of this comment is that if the US is indeed in a "new economy," previous reactions to recessionary conditions may not repeat themselves in this downturn.

Monetary & Fiscal Policy Makers

The Federal Reserve Board (Fed) is the central bank of the United States. They are responsible for setting and implementing monetary policy. The FOMC holds 8 meetings per year, which are widely watched for interest rate announcements or changes in growth expectations.

The Federal Reserve issues a biannual Monetary Policy Report in February and July followed by the Humphrey-Hawkins testimony where the Federal Reserve Chairman responds to questions from both the Congress and the Banking Committees in regards to this report. This report is important to watch, as it contains the FOMC forecasts for GDP growth, inflation and unemployment.

The Fed, unlike most other centrals banks has a mandate or "long-run objectives" of "price stability and sustainable economic growth." In order to adhere to these goals, the Fed has to use monetary policy to limit inflation, unemployment and to achieve balanced growth. The most popular tools that the Fed uses to control monetary policy include the following:

Open Market Operations: These involve Fed purchases of government securities, including Treasury bills, notes and bonds. This use to be one of the most popular methods for the Fed to signal and implement policy changes. As the Fed purchases government securities, they in effect decrease interest rates. When the Fed sells government securities, interest rates increase.

Fed Funds Target: This rate is the key policy target of the Fed. It is in essence, the level of borrowing that the Fed offers its member banks. The Fed tends to increase this rate to curb inflation or decrease this rate to promote growth and consumption. Changes in this rate tend to imply major changes in policy and typically has large ramifications for global fixed income and equity markets.

The US Treasury is responsible for issuing government debt and for making fiscal policy decisions. Fiscal policy decisions include determining the appropriate level of taxes and government spending. The US Treasury is the actual government body that determines dollar policy. That is, if they feel that the USD rate on the foreign exchange market is under or overvalued, they are the ones giving the NY Federal Reserve Board the instructions to intervene in the foreign exchange market by physically selling or buying USD. Therefore, the Treasury's view on dollar policy and changes to that view is very important to the currency market.

Over the past few decades, the Treasury and Fed officials have maintained a "strong dollar" bias.

Important Characteristics of the US Dollar

  Over 90% of all currency deals involve the USD.

  Prior to 9/11, the USD was considered one the world's premier "safe-haven" currencies.

However, post 9/11, foreign holders of US assets, including central banks have pared their USD holdings as a result of increased US uncertainty and decreased interest rates.

  Gold and USD tend to have inverse relationships.

This inverse relationship is developed as a result of the fact that gold is measured in dollars. Recent USD depreciation due to global uncertainty has been the primary reason for gold appreciation, as gold is commonly viewed as the ultimate form of money.

  Many emerging market countries "peg" their local currencies to the USD.

Pegging a currency to the USD pertains to the basic idea that a government agrees to maintaining the USD as a reserve currency by offering to buy or sell any amount of domestic currency at the pegged rate for the reserve currency. In addition, the government typically must also promise to hold reserve currency at least equal to the amount of local currency in circulation. Countries with currencies pegged to the USD include Hong Kong and China. This is particularly important because countries such as those will take an active interest in managing their fixed or floating pegs. Any fluctuations beyond this band will be subject to intervention by the central bank, which will include buying or selling USD.

  The Treasury and Fed favor a "strong dollar" policy.

  Interest Rate Differentials between US treasuries and foreign bonds strongly followed.

The interest rate differentials between US treasuries and foreign bonds is important to follow, as it is a strong indicator of potential currency movements. The reason is that investors are looking for assets with the highest yields. As yields in the US decrease or if yields abroad increase, this would induce investors to sell their US assets and purchase foreign assets. Selling US fixed income or equity assets would influence the currency market because that would require selling the USD and buying the foreign currency. If US yields increase or foreign yields decrease, investors would be more inclined to purchase US assets, therefore boosting the USD.

  USD Index.

Market participants closely follow the US Dollar Index as a gage to overall USD strength or weakness.

  US currency trading impacted by stock and bond markets.

There is a strong, positive correlation between a country's equity and fixed income markets and its currency.

Important Economic Indicators for the US

All of the following economic indicators are important for the US. However, since the US is a service-oriented economy, it is important to pay particular attention to numbers for the service sector.

  Employment

  Consumer Price Index (CPI)

  Producers Price Index (PPI)

  Gross Domestic Product (GDP)

  International Trade

  Employment Cost Index (CPI)

  Institute of Supply Managers (Formerly NAPM)

  Industrial Production

  Consumer Confidence

  Retail Sales