The US Dollar – A Game of Chicken?

Tuesday, October 20, 2009

1205956_cards_dollar_signsWith the economy and financial markets improving, the Federal Reserve Board could be close to allowing short-term interest rates to return to “normal”. This rise could be fairly fast and go quite far. As I described in “US Dollar’s Decline? Think Interest Rates, Not Inflation,” an interest rate increase will produce a worldwide gain in the US dollar. So, with this potential turnaround in exchange rates, why are investors betting on the dollar remaining weak and piling into contra-dollar investments (foreign currencies, global commodities and international securities)? And why are professionals engaging in “carry trade” where they bet the US dollar and interest rates will remain low?

My feeling is that it is another game of chicken. This time, investors think they can hit the exits just before rates increase and the dollar rises, thereby maximizing gains and avoiding losses. This losing game occurs whenever a strategy or trend has been profitable for some time. What happens is that the positive returns create popularity, boosting confidence and attracting analytical support of the trend continuing. The Wall Street Journal offers these analytical examples: “No Relief in Sight for Dollar” (yesterday, page C-2) and “Risk Appetite Keeps Dollar on Heels” (today, page C-10).

So, how close are we to an interest rate/dollar reversal? Could be soon. Economic, financial and industry improvements keep rolling in, allaying fears and even beating positive expectations. So, the need for abnormally low interest rates is disappearing. Also, remember that there is about a six-month lag between Fed actions and economy reactions. The Board cannot wait until the signs are crystal clear.

Now, look at what the Fed is doing, not what it is saying. They are testing a Wall Street strategy for unwinding their excess US Treasury bond holdings to remove the excess money supply. (As I showed in “Ben Bernanke Discusses Fed Balance Sheet Tomorrow,” the bond holdings are now the bulk of the Fed’s excess assets.) This action will cause interest rates to rise. In order not to spook the markets, the Fed issued a soothing statement saying, in essence, “This is just a test.” Well, the test proves the tool works, and the conditions seem right, so….

If the Barron’s cover article, “It’s Time To Raise Rates, Ben,” is correct, now is the time not to own foreign currencies, global commodities or international securities.

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