PERFORMANCE ANNOUNCEMENT

As Of: January 4, 2006

THE YEAR AHEAD

What are the signs to watch?

    There are many cross-currents in the economy that are causing people to scratch their head over what to expect for 2006. One topic that does not seem to surface very often in the conversations, is the fate of the U.S. dollar. As abstract as this may be for most Americans, I suspect that the strength (or weakness) of the dollar may be the keynote that sets the stage for the other events of the year.

    With the release of the notes from the Federal Reserve open market committee meeting, a belief has now taken hold that the FED is essentially finished raising interest rates. The big market news was that the yield on the two-year Treasury note dropped, and the previously flat yield curve regained a little slope. But while investors have remained focused on interest rates, I wonder if they have their eye on the wrong ball. Simultaneous with the confirmation that the FED is close to the end of interest rate increases, the U.S. dollar took a dip. Is this a harbinger of things to come?

    Part of the discussion regarding interest rates revolves around the handoff of the chairmanship of the Federal Reserve from Alan Greenspan to Ben Bernanke. It is not uncommon for markets to test the mettle of a new chairman, and there is a lot of discussion whether Mr. Bernanke will raise or lower interest rates. My personal opinion is that if there is going to be a test, it is most likely to come from the currency markets. If the U.S. dollar starts to drop significantly, will the Federal Reserve work with the Treasury to try to support the dollar, or not? This may be a choice between the frying pan and the fire. The normal way to support the dollar would be to raise interest rates to attract foreign capital. However, with a multi-trillion dollar housing market in the United States on the brink of entering a downward spiral, higher interest rates could precipitate a severe economic downturn. On the other hand, if the dollar is allowed to sink, foreign capital is likely to withdraw from the U.S. markets. The United States is now a debtor nation, and we are fully dependent on foreigners to purchase our debt. Without support for the dollar, the free market will tend to push the price of bonds down and interest rates up. Furthermore, without support for the dollar, the price of international commodities such as oil will tend to go up. So the choice will be difficult if the dollar is put under pressure. I believe one of the reasons gold has been trending up is due to a tacit understanding of currency risk.

    One of the results of this line of reasoning is an understanding that interest rates may not do what the Federal Reserve or politicians want them to do in the absence of outside pressures. The yield curve may change in an unanticipated way, and the FED does not have direct control of long term interest rates. It is also possible that interest rates may have to keep going up, even though the general expectation is that the Federal Reserve should be done raising rates. I am not confident that I can predict exactly what is going to happen, but I do believe that watching the U.S. dollar will give an advance signal of the future possibilities.