On July 15, traders in Europe knocked the dollar to an all-time low of $1.6020 to the euro and a three-month low against the British pound. It was hardly a surprise: Investors around the world were appalled by the U.S. government's need to rescue the multitrillion-dollar mortgage behemoths, Fannie Mae (FNM) and Freddie Mac (FRE), last weekend. "We don't want government-sponsored enterprises in trouble," says Adrian Mowat, Asia equity strategist at JPMorgan (JPM) in Hong Kong. "That's not good for the U.S. and not good for the rest of the world." The Asian markets duly punished banks that held Fannie and Freddie paper.
But to the surprise of many traders, instead of plunging to uncharted depths, the dollar managed to bounce back and was trading at about 1.584 to the euro on July 16. "A lot of hedge funds were confused by the price action," says Stephen Jen, currency strategist at Morgan Stanley (MS) in London.
Jen and other analysts think several factors have helped—at least, so far—to keep the dollar from going into the out-of-control downward spiral that many fear could be coming. For one thing, the greenback is already quite cheap, especially against the euro, making investors wonder how much lower it can go. But what may be even more important is that the wave of economic misery that began in the U.S. last year is clearly starting to hit European economies, as well.
Already, countries at the fringes of Europe, including Denmark, Spain, and Ireland, are in recession or the throes of housing crises. Downward-pointing economic indicators suggest Britain is headed for recession (BusinessWeek.com, 7/16/08). And now even Germany, which has boasted a surprisingly healthy economy during the subprime woes, is starting to look sick. Industrial production dropped in April and May, the latest months reported, and such large companies as Siemens (SI) have announced job cuts (BusinessWeek.com, 7/8/08). "That the dollar was extremely cheap didn't matter until the German data started to turn negative," Jen says. "The combination was enough to cap the euro/dollar rate."
Nevertheless, with confidence low worldwide, investors likely will continue to watch the dollar, fearing that it could become the next victim of fallout from the financial crisis. "The dollar is taking center stage in global financial markets," says David Woo, currency strategist at Barclays Capital (BCS) in London.
In recent months, Woo says, the dollar's exchange rate against the euro has become closely linked to oil prices. In an econometric study, Woo found that a 1% increase in the euro/dollar rate leads to a 1.2% rise, on average, in oil prices. This tight correlation helps produce what Woo calls a "vicious circle," in which U.S. interest rate cuts boost both the euro and oil prices, thus increasing inflation and encouraging the hawkish European Central Bank to hike rates further, which then keeps the process in motion.
"Rising energy prices and the falling dollar are becoming mutually reinforcing," Woo says. "That's why the downtrend of the dollar and the uptrend of oil have become so stable." These trends also make it difficult for the Fed to keep cutting rates to bolster the ailing U.S. banking system and to reignite growth.
Woo says that the long fall of the dollar over the past five years has "brought more good than bad." It has helped boost U.S. exports, making inroads into the current-account deficit while not creating much inflation. But now the dollar's decline is hurting the U.S., because the weakness is being passed along to consumers in the form of higher energy prices, which, among other things, have largely negated the Bush Administration's tax rebates.
Further declines in the dollar also run the risk, Woo thinks, of setting off a disorderly selling spree of U.S. assets and discouraging foreign central banks and sovereign wealth funds—which funded more than 98% of the $176.4 billion current account deficit in the first quarter of this year—from continuing to soak up U.S. debt (BusinessWeek.com, 7/15/08). That's why he believes the U.S. will likely intervene if the euro moves "sustainably above $1.60."
Awareness in the markets that intervention is a growing possibility is probably another reason the dollar didn't plunge further on July 16. The sharp selloff in oil prices that began on July 15 was also positive for the dollar. Indeed, the fact that the greenback kept its head above water could signal a turn, or at least a temporary bottom. But don't count on it.
With Frederik Balfour in Hong Kong and Kenji Hall in Tokyo