Saturday 16 April 2005

When US dollar psychology changes

The Treasury International Capital data for February looks good for the US dollar, with the US getting US$84.5 billion in financing from overseas, enough for it to cover its current account deficit.

But with inflation fears and Federal Reserve rate hikes in the air, I thought this passage from James Picerno at the Capital Spectator is also pertinent to the outlook for the US dollar:

Perhaps there's a logic to a stronger dollar even inflation were to accelerate. The fear of higher inflation and a Fed that reacts by tightening the monetary strings makes the greenback more attractive, say some analysts. But this notion assumes the Fed's committed to fighting inflation at the expense of letting Joe's shopping sprees of late fade into history. But the assumption could be over baked, which is to say that the old dual mandate of protecting the currency and maximizing national employment at the same time may come back to haunt the central bank once again.

Peter Schiff of Euro Pacific Capital is about as pessimistic as one can get on the speculation as to how the Fed will decide which is the bigger priority. The central bank, he opines, "can not bring down the inflation tree, without simultaneously bringing down the entire U.S. economy, which at present is comfortably resting in its extended branches." Once forex traders see the light, he reckons, "bad news on inflation will once again be reacted to as being bad news for the dollar."

Brad DeLong looked at how a change in trading psychology might unfold.

The long run in which the dollar falls and U.S. long-term interest rates rise may come like a thief in the night as a very sudden shock. If it comes as a sudden shock rather than as a long, slow, gradual realization, it will come on that day when the gestalt of the players on Wall Street and elsewhere changes, and when they collectively regard holding dollars as the more risky rather than the less risky strategy in the short run, when they collectivley regard being long long-term U.S. Treasuries as the more risky rather than the less risky strategy in the short run. On that day the long run future will be, as football coach George Allen used to say, now.

Somehow, my commentaries three years ago -- "New paradigm for the US dollar?" and "Analysts risk overestimating the value of the US dollar" -- still seem relevant today.

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