Dollar Respite Unlikely to Endure

July 15, 2008

The dollar at this hour is more than a penny stronger than its earlier record low today of $1.6038 per euro.  Fed Chairman Bernanke’s more alarmist remarks about the outlook for U.S. growth drove this respite, first sending oil prices sharply below today’s high of $146.73, which in turn boosted the dollar and trimmed some losses in equities.  The strength of oil prices has withstood softer U.S. growth all this year.  Oil price strength stems from the heavy demand of China and other emerging markets and the expectation of enduring strong demand that is persuading oil producers not to rush supply to market.  It would make sense to do such only  of the spike in world demand were thought likely to be temporary. 

Commodity price pressures have caused stagflation, which evokes different responses at the ECB and Fed.  Officials at the ECB cannot cut rates despite weakening growth, and their U.S. counterparts cannot raise rates despite accelerating inflation and a weak currency.  Oil prices averaged less than $100 per barrel as recently as 1Q08, so a retreat such as that seen this morning represents but a drop in the bucket of relief for the damage to growth and inflation that is in the pipeline already.

The Fannie Mae/Freddie Mac story augments the dollar’s near-term vulnerability.  Investors agree that these GSE’s are too big and important to fail, and the financial community, which saw how quickly Bear Stearns imploded, remains unconvinced that the the GSE’s can be rescued in a way well short of nationalization.  From a currency investor’s point of view, either Fannie Mae and Freddie Mac share prices rebound significantly and in a sustaining way, which looks more and more doubtful by each passing day, or the U.S. Federal debt is about to take a quantum leap, and that scenario almost certainly will hit the dollar hard.

Finally, the lack of bite in Fed Chairman Bernanke’s verbal support for the dollar is fresh in the market’s mind.  Last month, he laid out a cogent case against endless neglect of dollar weakness.  One reason officials choose their words so carefully when discussing foreign exchange policy is that it’s very important that one can back up promised intentions.  Currency market history is full of instances when empty currency boasts by officials were punished severely by the market.



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