Firmer Dollar Tone

May 4, 2008

The dollar strengthened further last week. Larger gains were posted against the Swiss franc and euro than against the yen or sterling, and the greenback actually dipped marginally against the kiwi and Australian dollar. Compared to its 2008 lows, the dollar at the close last Friday had rallied 10.1% against yen and 9.7% against the Swissy but just 3.9% against the euro, 3.3% against the pound and 1.5% relative to the Australian dollar. The relative strength of high-yielding currencies against low-yielders is symptomatic of a revival of risk aversion in all financial markets. Stronger equities, lower long-term bond prices, and softer gold prices also reflect a revived interest in risk-taking.

Dollar sentiment was lifted by U.S. labor statistics that were not as bad as feared and continuing above-zero readings on U.S. growth. At the same time, Japan and Europe show signs of broadening fatigue, and Fed support is rotating away from the cutting of interest rates and toward direct infusions of liquidity to enable banks to rebuild their capital at taxpayers’ expense.

The G7 protested recent currency movements on April 11th, saying, “Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability,” when the dollar was worth only 1.5830 per euro and 100.3 yen, 2.7% and 5.1% less than now. Officials had been urged repeatedly before the G7 meeting not to neglect the dollar, and the new currency policy language showed that the advice had been heard. To promote better two-way dollar risk, central banks do not necessarily have to buy dollars, nor must the Fed lift interest rates. A well-timed shift in verbal signals will often suffice in the short term. A juxtaposition of some better-than-assumed U.S. economic data and weakening Japanese and European trends made the timing of the G7 verbal shift well-placed indeed.

In the week ahead, I expect interest rate meetings in Euroland, Britain and Australia to each leave monetary policy unchanged. Additional proof a slower European growth will emerge such as a decline in German industrial production. Nothing is likely to be said to quell the dollar’s recovery. The on-set of tax rebates in the United States will boost confidence that a recession, assuming there is one, will be mild and brief like the last two. Even if disproved, the failed logic will not be exposed very soon. It will not be surprising if the dollar extends its recovery, but incremental appreciation is unlikely to amount to much from present levels.

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