Thursday, July 17, 2008

The Dollar Malaise

Negative sentiment towards the dollar has reached fever pitch proportions over the past week and for once it is not weak economic data that is the driving force. No, rather it is the US Government’s plans to shore up ailing mortgage lenders Fannie Mae and Freddy MAC that has put the frighteners on investors. If the US government needs to follow its plan with actual cash, the cash will come from the taxpayer, via issuance of more government debt. And let us face it, we are not talking about small numbers here, but mind-boggling figures that run into the trillions, potentially pushing the country to even more extreme debt proportions and undermining the value of the US dollar. Markets have been spooked by this prospect and a report in the Financial Times today about some sovereign wealth funds diversifying out of US dollar assets is hardly a surprise. A major loss of confidence in the future direction of the dollar on the part of major debt holders is a very serious concern for the US Treasury and it is the one thing that could potentially trigger some market intervention, if the fears of these debt holders do not abate soon. Despite clear evidence of a marked slowdown in European economies, the currencies of these countries have no difficulty hammering the dollar, on an almost daily basis at present, as the US currency appears incapable of holding onto gains for anything more than a few hours at a time. Investors have thus far been happier to forgive Europeans economies for their underperformance, rather than be caught holding low-yielding US dollars. It is clearly a mistake to believe these European economies are going to ride the storm and come out smelling of roses, but for now the focus is less on economic data and more on market fear about the future of the US financial system. Although US inflation (5% in June) is running higher than that in the euro area (4% in June) and the UK (3.8% in June), the chances of a US interest rate hike are dwindling with the Fed stating its overriding focus is a resolution of the credit crisis. The Fed expects inflation to moderate as growth eats into demand. Markets still expect to see the ECB hike at least once more, while the Bank of England is also seen leaning on the hawkish side, which is justifying the recent rush of cash into European currencies. This is merely a short run play, because eventually the European Central Banks will creak under the weight of an accelerating downturn and will need to soften their tone. When they do, it will mark the beginning of a dollar revival. If they wait too long, or believe rate hikes are the way forward even against slowing growth, then we are certainly in for an even more extended period of discontent for the US dollar.

Ted B - Jul 17

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