Stephen King: Persistent dollar doldrums could weigh heavily on Europe

It seems the market is now much more attuned to the dangers of a US hard landing

Taken together, the past few days may prove to be a defining moment in the progress of the world economy. Having just been through one of the strongest periods of global economic expansion since the early-1970s, suddenly the pace of economic growth seems to be wilting. Financial markets are becoming increasingly jittery.

The Federal Reserve says inflation is the main risk in the US, but traders and investors no longer agree. If inflation was the main fear through much of this year, it looks as though economic growth - or the lack of it - will be the main concern through 2007. US interest rates may soon be coming down.

The source of these growth worries is the US economy. At the beginning of 2006, the most obvious downside risk for the US economy was the housing market. Was it a bubble and, if so, might the bubble burst? The majority of forecasters suggested a slight housing correction. The consensus pointed to 1.89 million housing starts in 2006 followed by a further 1.8 million starts in 2007. In October, however, housing starts amounted to an annualised 1.5 million. The scale of collapse has been greater than the majority of economists expected.

Once it was obvious that housing was in freefall, the debate moved on. Housing could collapse, apparently, but the rest of the US economy was immune. In particular, the link between housing and consumer spending was tenuous and, with consumer confidence still high, there was no reason to fret about an overall slowdown in the pace of economic expansion.

Yet a more broadly based slowdown is under way. At an annual rate, US growth faded from a ballistic 5.6 per cent in the first quarter of 2006 to a more modest 2.6 per cent in the second quarter, and then to a rather sedentary 2.2 per cent in the third quarter. Admittedly consumer spending has held up and the labour market has, so far, remained robust, but the signs of weakness are beginning to multiply. Manufacturing activity has been shrinking over the past couple of months, durable goods orders point to a reduced appetite for capital spending and, last week, the Institute of Supply Management's latest reading for the economy was consistent with a manufacturing recession, if not with a recession for the economy as a whole.

It's difficult to tell at this stage why, precisely, these business indicators have weakened quite so much. After all, US company profits are still amazingly high, so the ability - if not the willingness - to invest is certainly there. Perhaps with rising inventories, companies are being forced to cut prices: good news for consumers in the short-term, but a signal that the profits boom may be drawing to a close. If so, consumers may also eventually be hit: with softening profits, it will be only a matter of time before the labour market starts to weaken, either through downward pressure on wages or upward pressure on unemployment.

So far, the data is sufficiently ambiguous to make it difficult to tell whether the current slowdown will prove to be a "soft landing" - which I would define as a situation where unemployment and profits are broadly unaffected by a temporary slowdown in economic growth - or a much less pleasant recession-like "hard landing".

Clearly, the balance of risks has changed. The Fed might still be warning about the dangers of inflation and the possible need for further interest rate increases, but everyone else is now fixated on the downside risks to growth.

This perceived shift in the balance of risks has already had a big impact on a range of financial variables. Bond markets have rallied. 10-year Treasury yields - which are akin to the expected average level of short-term US interest rates over the next 10 years - have come down dramatically. During the summer, they had risen to 5.2 per cent but they're now below 4.5 per cent.

With the Federal Reserve's target interest rate currently at 5.25 per cent, investors are saying that there should be rate cuts aplenty to come at some point over the next couple of years.

With lower rates comes a weaker dollar. To date, the softening of the US economy has not had much of an impact on activity elsewhere in the world: business surveys in Europe have been robust, growth in emerging markets has held up and, despite a continued absence of consumer demand, Japan has just about kept its head above recessionary waters.

As the US economy has disappointed, so the dollar has lost its tumescence. Other currencies have been able to demonstrate some hitherto-dormant virility: the euro has gone from strength to strength, the yen has picked up and sterling is in danger of heading out of the stratosphere and into a new, higher, orbit. The $2 pound beckons.

Meanwhile, equities, which had enjoyed the rub of the green earlier in the year, have had a harder time of late. If the US economy really is slowing down, with profits perhaps having passed their zenith, there's less for equity investors to get excited about. True, equities are nowhere near as expensive as they were back at the height of the technology bubble in 2000 but, nevertheless, we may have moved beyond the "sweet spot" that had helped equity values rise sharply in recent years.

Of course, there are always alternative explanations for dollar weakness. One doing the rounds is the idea that the dollar is softening because emerging market central banks, awash with cash as a result of persistently large balance of payments current account surpluses, are diversifying out of dollars into euros, yen, sterling and anything else that isn't a dollar.

But, for me, this argument doesn't really stack up: emerging market central banks tend to buy Treasuries with their dollars so diversification out of dollars should also have meant the sale of Treasuries. Yet Treasuries have strongly rallied.

So it seems the market is now much more attuned to the dangers of a US hard landing. Doubtless, more soft data will persuade the Federal Reserve to change its mind, making 2007 a year of persistent cuts in US interest rates.

For the rest of the world, though, it would be wrong to look at the US with the schadenfreude that all too often typifies periods of US economic decline. With many emerging markets still happy to "manage" their currencies against the dollar, US currency weakness almost inevitably translates into European currency strength. While that makes our holidays in Florida and our shopping in New York that much cheaper, it also means that Europe - both the UK and the eurozone - ends up losing competitiveness.

To date, there have been few signs of European economic weakness to match the slowdown seen in the US. Persistent dollar doldrums combined with softer US demand could change all that. During 2000 and 2001, the US slowdown proved to be much more aggressive than the eurozone's. Then everything changed. While the US staged a robust recovery, the eurozone stagnated (see charts).

The UK did a lot better than the eurozone primarily because, back then, Gordon Brown had lots of room to increase public spending. As he puts the finishing touches to this week's pre-Budget report, he knows that, this time, there can be no fiscal safety net: the budget deficit is already too large. If demand-boosting policy changes are needed in the UK, they'll have to be delivered by the Bank of England, not by the Treasury.

In the past, where the US has led, others eventually have followed. I'm not convinced this time will be any different.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com