Wednesday, November 5, 2008

Dollar weaker, even as fear returns to stock markets

I've heard a lot of people commenting in the last two days that the reason the dollar has fallen back is because the so-called, "flight to safety" element has been removed. In other words, now that stock markets have stabilized and credit market spreads are narrowing, the dollar's decline was merely the markets' way of sending an "all-clear" sign.

I didn't see it that way.

With all the problems in Europe and elswhere, the dollar should have kept rallying. The world was short of dollars and still is, in a big way.

The reason the dollar has stopped falling is simple: Forex participants now understand that the Fed will provide dollars to any European institution (or Brazilian, Taiwanese, S. Korean, Mexican...) with dollar liabilities through the ECB or respective central bank, rather than see asset sales and/or the purchase of dollars in the open market. Therefore, for now, further dollar appreciation appears to be a low probability or even out of the question.

Down the road, however, it is possible that portfolio investors favor the dollar over the euro if they see U.S. conditions improving and Eurozone conditions worsening. However, it’s hard to assign a probability to that.

The Fed has missed a golden opportunity to let the dollar appreciate, with little or no policy adjustment. It would have brought important benefits on the inflation front, in terms of trade to U.S. consumers, and with respect to the asset holdings of central banks around the world like China, that hold lots of dollar denominated assets.

Instead, they put a cap on the dollar’s rise.

Personally, I find this hard to understand. The benefits of letting the dollar rise because of a technical “condition” rather than having to implement a major policy shift seem to outweigh the risks. Perhaps they felt that asset sales by foreign institutions would have some contagion or systemic impact? But even that doesn’t make sense because if they’re worried about contagion and systemic impact, why did they let Lehman fail?

I am baffled. Absolutely baffled.


Matt Franko said...


Im thinking perhaps recent $ weakness may be related to price of oil in addition to the Feds swaps.

I think when Euro went below $1.25 recently, oil was testing $60. Oil has recently been back up to $70.

If oil breaks $60 and looks like its heading to $50, probably a lot of us$ denominated loans made by foreign banks outside the US ( w/ oil $100+) are going to be in some trouble over there again, creating some us$ shortages again.

Also, Ive been following you wrt these currency swaps and over the last week or two, it looks to me like the ECB provided $230B or so to the system over there via the Feds TAF auctions. Looks like the Fed/ECB are using the TAF auctions to conduct the currency swaps.

See interesting ECB monetary operations link here.

If you look at the pace of these ECB auctions, I dont think the Fed can provide us$ to the ECB at a $500B per month rate for very long! Even with all of this the Euro is still below $1.30...
Im going to hang in for now with my short Euro and long Dollar index positions hoping for weaker oil and Bush admin that will now punt these solely European problems to the Obama admin. to deal with next year...


PS Thanks again for your blog and radio show!

Mike Norman said...

Yes, I saw your earlier post, but didn't have time to respond. I don't think it goes through TAF because Term Auction Credit is a separate line item on the Fed's weekly Statement, whereas "Other Federal Reserve Assets (which contain foreign currencies) is listed separately.

STF said...

Been reading your blog regularly since Warren's site admin provided the link. Great stuff . . . keep it up and thanks!
Scott Fullwiler

Mike Norman said...

Hey, thanks, Scott! I'd love to get you on my radio show.