For a while during the worst of the crisis, dovish words and deeds by central
banks could actually strengthen their currencies. Traders liked hearing that
central bankers were alive to the seriousness of the situation.
Those days are over. The Federal Open Market Committee said on Tuesday that it
was “prepared to provide additional accommodation” and showed a real concern
about deflation.
Dollar unloved
The dollar fell. Technical patterns also suggest that the dollar is unloved.
On a trade-weighted basis, the buck dropped below its 200-day moving
average, a measure of long-term trend, last week.
One-way bets in the foreign exchange market are dangerous. Bearishness towards
the dollar is driven by fears that printing money will lead to rising
prices.
Inflation low
But the US inflation rate is at a 50-year low and fixed-income markets suggest
expectations are well anchored. Also, the dollar at $1.34 to the euro is 17
cents below fair value, according to the International Monetary Fund’s
measure of purchasing power parity.
If fear of inflation is making the dollar cheap, however, then logically it is
a screaming buy at the first sign the US is slipping into Japanese-style
deflation. This is where things become muddled.
To be sure, if deflation raises real interest rates vis-à-vis other countries,
the dollar should strengthen - particularly as many other central banks are
trying to weaken their own currencies. Trouble is, the Fed’s commitment to
ultra-low nominal rates gives investors comfort to borrow heavily in dollars
to invest in higher-yielding assets denominated in other currencies.
Carry trade
There is no reliable data on the true extent of so-called carry trading. But
many think carry trades kept the yen unnaturally weak for years.
Investors who are short the dollar might want to see how that ended: from July
2008 versus the Australian dollar - a popular carry trade - the yen doubled
in six months. Ouch!
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