FRONT PAGE CONTRIBUTOR
Emerging Theme in Financial Markets: The US Dollar is Getting Stronger
Capitulation and Decoupling
A vast movement involving enormous amounts of capital is now underway. Investors around the world are buying dollars again. And they’re selling the oil, gold and other commodities that have been serving as a hedge against dollar weakness since the Federal Reserve started aggressively cutting interest rates eleven months ago.
As I write, the US dollar is trading above $1.50 to the euro. The dollar’s low point was below $1.59 earlier this year. This morning’s additional strength follows a very sharp gain on Friday. Crude oil is up slightly after a stunning drop on Friday, and gold is little changed.
What set off the stampede, and what happens next?
It’s probably not true that the dollar is getting stronger (but more on that in a moment). The euro, however, is definitely getting weaker. On Thursday, Jean-Claude Trichet (the governor of the European Central Bank, or ECB) reiterated his prior statements that economic conditions in the Eurozone are worsening rapidly. Meanwhile, the US economy continues very weak, but still growing perceptibly as the export sector remains hot as a firecracker.
So expectations are for lower interest rates in Europe, and continued steady rates in the US. The problem with all this is that Trichet and his surrogates have been saying throughout the year-long credit crisis that their top priority is to control inflation, even at the expense of growth.
At this moment, however, inflation is roaring in Europe (Germany reported a nearly 10% annual rate of increase in producer prices for July, a shockingly large number and far above expectations), but output is slowing rapidly.
Trichet also tried to say something like “Don’t you know that evewy move we make is cawefully planned?” But the markets didn’t bite this time. Hence the decline of the euro relative to the dollar.
News reports are indicating this morning that expectations have turned in favor of a rapid economic recovery in the US, which (all else equal) would put upward pressure on interest rates and thus strengthen the dollar.
But I’m not buying it.
There is another very strong structural factor which is propping up the dollar, and is usually overlooked. That is the insatiable appetite of “official” investors (generally central banks and sovereign wealth funds) for US Treasury debt. The extremely large issuances of long-dated notes and bonds by the Treasury last week were received very well overall (overlooking the to-be-expected raggedness and localized disturbances caused to such a large issue). And short-dated bills and notes continue to receive strong bids.
Meanwhile, the spread between dollar-denominated risk-free debt and risk-bearing debt is extremely high right now. It’s always high during recessions (that’s how banks rebuild their balance sheets), but this is across the board and being sustained for a long period of time, even in the absence of an “official” recession.
In short, the world would rather park capital with the US Treasury than invest it nearly anywhere else. Extreme risk aversion continues to be the order of the day. And you can’t have sustained growth without taking risk.
So the fact that the dollar is the world’s safest and most trusted money by far, will ultimately serve to support its value. The dollar rally appears to have legs.