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The Diving Dollar: Don't Fret -- Yet

By David Ethridge Where's the bottom for the U.S. dollar? The greenback continues to reach new record lows vs. the euro and has weakened considerably in relation to Asian currencies as well. The combination of a sliding dollar and a spike in gold prices to 15-year highs is feeding underlying anxiety that the days of low U.S. inflation are coming to an end -- and that interest rates are poised to move higher as the Federal Reserve finds it more challenging to maintain its accommodative stance.

The stock market may be oblivious to these trends -- steaming to new recovery highs over the past few weeks. But the bond market has taken it on the chin. As 2004 begins, prices of U.S. Treasury securities have been hurt by continued weakness in the greenback and higher commodity prices, led by the spike in gold.

U.S. monetary officials aren't pressing the panic button just yet. Leading lights at the Fed remain fairly relaxed over the dollar's decline so far, calling it relatively orderly and not extreme on a broad trade-weighted basis, as was the case in the 1985-87 period, when a sharp drop in the dollar led to a dramatic plunge in stocks and bonds.

FOREIGN SUPPORT. In a speech in early January, Fed Governor Ben Bernanke expressed little concern over a dollar crisis and downplayed the inflationary implications of the greenback's decline vs. the surging euro and other major currencies. Moreover, the Fed's point man on deflation says he believes the direct effect of the depreciating dollar (e.g., rising commodity prices) is relatively small on consumer prices. He estimates that a sustained 10% drop in the broad value of the dollar would add between 0.1 to 0.3 percentage points to the consumer price index over time.

To provide some context, Bernanke noted the Fed's "broad" trade-weighted index measuring the dollar vs. a basket of other world currencies is down 12% from its multiyear peak reached in February, 2002. This index also remains about 7% above its average value in the 1990s and 17% above its record low set in 1995. This compares with a 28% drop in the narrow Finex dollar index of six major currencies, of which the euro accounts for the lion's share.

Massive dollar buying by certain Asian foreign central banks has helped slow the greenback's fall and limited the upward march of Treasury yields (prices move opposite to yields), especially among shorter-dated issues. It was no accident the average balance for foreign central banks in the Fed's official custody holdings -- a measure of amounts held of U.S. government and agency debt -- jumped to an all-time high in 2003. Without such official and ongoing buying support, the dollar would likely be lower and bond yields higher.

STRONGER PUNCH. The Bush Administration continues to give lip service to a "strong-dollar" policy, but it has left the fate of the U.S. currency to the market's daily ebb and flow. U.S. policymakers are traditionally loath to intervene in currency markets on behalf of the greenback, though they continue to look the other way as Japan and China sell their home currencies to slow the dollar's slide. Rather than address politically thorny currency issues, Team Bush has been trying to resolve free trade issues on a narrow, case-by-case basis (see BW Online, 11/24/03, "On the Verge of a Trade War?").

What should Wall Street expect from Washington as the dollar continues its decline? Whether by luck or design, the Fed and the Treasury Dept. together have aimed the real economy toward boom times, with a tech-led factory sector starting the New Year with a full head of steam.

Current U.S. policy of a weaker -- but not deathly ill -- dollar is adding oomph to the one-two punch of interest rates near multidecade lows and the Bush Administration's pro-investment tax cuts. All of these factors have combined to boost U.S. corporate profits -- a key driver for capital spending and employment.

SPEED LIMIT. Still, managing the currency side of the equation could prove tricky. So far, the dollar's decline isn't preventing stocks from moving higher, while bond yields remain quite low, with the Fed-sensitive two-year note still yielding under 2%. The last time the dollar had a significant fall vs. other major currencies -- during the 1985-87 period -- it dropped over 20% before bond yields started to move clearly higher and stock prices began to dive in 1987.

U.S. officials most likely will remain calm over the dollar's fall as a side effect of their policy efforts to reflate the economy, as long as that slide remains orderly. But should the dollar's decline accelerate on the order of its 1987 plunge -- and the stock and bond markets begin to suffer collateral damage -- policymakers may be forced to mount a more vigorous defense of the U.S. currency. Ethridge is a market analyst for Informa Global Markets (formerly MMS International)

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