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.