INTEREST RATES ARE ALL THAT MATTER:

The dollar is on the comeback trail: The US dollar's obituaries in December were perhaps a little too hasty. The United States' soaring current account deficit was a horse that analysts flogged too hard to justify the plunging dollar. But since the Federal Reserve is the only central bank in rate-hiking mode, the dollar's newfound gallop could be here to stay. (Jack Crooks, 1/19/05, Asia Times)

The Economist magazine said on January 1, 2005, "The cause of the dollar's decline is hardly a mystery: private investors are less eager to finance America's huge current account deficit." Keynesians, New-Keynesians, Monetarist and Austrians are of one mind on this point.

Granted, the soaring current account created the fertile ground to swing dollar sentiment decidedly negative. But is the current account the key reason for the dollar's decline? Or is that, in our zest for rationality, we irrationally give greater weight to those variables we can identify, as opposed to those we cannot, which unfortunately represent the bulk.

The number of underlying fundamental variables impacting the dollar is both diverse and illusive. This is why currency trading appears so irrational. It is irrational much of the time, especially as we narrow the time frames. It's why currencies are more vulnerable to investor sentiment than any other asset market. It's why we see such large "over shooting" in the currency markets. But none of this nullifies the eventual impact of the real underlying drivers of currencies; it only makes them harder to identify.

So, the current account became the key indicator in the currency forecasting game. Most commentators have focused on the current account because it was an easy story to tell. However, in addition to the current account story, there were plenty of reasons why the dollar may have declined in 2004, and in preceding three-years. Here are a few...

1) The yield on US dollar deposits declined relative to other major currencies

2) The bursting of the stock market bubble in 2000

3) The Fed's decision to run the printing presses 24/7 to fight deflation (supply and demand)

4) China supplanting the US as the world's major destination for foreign direct investment

5) Foreign concern about US-dominated assets following September 11 and the "war on terror".

But then he gets to the only thing that matters:

[T]he Fed Funds rate is going higher. And I think it will surprise traders how quickly it rises relative to other benchmark rates around the globe. Why? Because the next move from the UK might be down as its property market deflates. Australia is in a holding pattern, with a current account problem, commodity price dependence, and declining property prices. The European Central Bank is on hold, indefinitely, until the morbid job market responds. Japan is stuck at zero. That leaves Canada, another ex-high yielder relative to the US. The Bank of Canada will most likely play wait-and-see on the commodities front before it signals any action. Already the higher Canadian dollar has taken its toll on exports.

That means the US should win the hot money game when it comes to interest rates. And we shouldn't underestimate the self-feeding potential from speculative capital flow on a currency.

If the Europeans are done choking their own economies with artificially high interest rates and Mr. Greenspan has decided to choke ours instead, just for the sake of a "strong" currency, then the dollar will indeed go higher. But he should be stopped.

Posted by Orrin Judd at January 19, 2005 6:21 PM