Dollar Trouble

The minutes of the latest FOMC meeting showed that the Fed reiterated its decision to keep rates at low levels for an extended period of time… No surprises there. However, certain parts of the November minutes hint that Fed officials are keeping an eye out for on potential downside risks of having low interest rates.

In particular, the Fed is concerned that its interest rate policy might spur excessive risk taking in the markets, while a couple of Fed officials also cautioned that low rates might bring about an inflationary environment. Recall that the Fed implemented rate cuts in order to stimulate growth and demand during the last Dark Age, err, economic recession. Now, some are worried that keeping rates low for an extremely long time might boost demand so much that price levels would keep rising and rising. Yikes! At the end of the day, majority of the committee members reassured that rampant inflation wouldn’t be a threat, adding that other constraints to economic growth would keep it in check.

Aside from the promising price stability for the coming years, the Fed also gave a relatively upbeat outlook for the US labor market. The unemployment rate currently stands at 10.2% but the FOMC estimated that, by the end of 2010, it would fall between 9.3% and 9.7% – a downward revision from their previous forecast of 9.5% to 9.8%.

The minutes of the meeting also revealed that the Fed is concerned about still worsening credit conditions. It was mentioned that small businesses and individuals are still having a tough time securing credit, despite continued capital easing in the financial markets. Fed officials noted that only large companies, not smaller firms, are able to take advantage of the increased liquidity.

Okay, so we got all the things that the Fed said… but what about the things they didn’t say? You know, that thing about the possibility of growth being subdued because of the persistent decline of the dollar’s value?

I said in my previous post that the big boys at the Federal Reserve should just quit with all their jawboning and start walkin’ the walk! And you know what? The FOMC meeting minutes just cemented my belief that they will do absolutely no concrete action to support the declining value of the dollar. Zilch. Nada. Zero.

If anything, instead of giving support, the Fed actually encouraged currency traders to diversify out of the dollar! They gave an upbeat economic outlook for the US economy BUT, at the same time, indicated that interest rates will remain at record low levels for an extended period of time… Another way of saying a long, long, long, long, long time. They practically gave currency traders two big thumbs up to saying “Keep doing what you’re doing – don’t worry, we won’t get in the way!”

If you’ve been paying attention to my blogs, you’d surely know that the dollar has been on a major slide. A lot of this was credited to recent economic data that has boosted risk appetite. With more and more signs of economic recovery, investors are looking for higher yielding assets and are shying away from the dollar. Why? One reason has been, as I’ve said above, low interest rates. With the Fed slashing rates to near zero, we’ve seen investors use the dollar as a funding source for their investments in higher yielding assets.

Now, let’s take a look at yesterday’s action. Once again, the USD hit new lows as investors decided to sell the bloody hell out it. With investors frantically selling the poor buck, the EURUSD busted past the 1.500 price level, hitting as high as 1.5160, while the Swiss Franc hit parity (1.000) against the USD! While we could say that the strong dollar selling was due to run of risk appetite, there was something else at play as well that contributed to dollar weakness – fear of reserve diversification.

Russia contributed to reserve diversification fears, saying that it wanted to get more Loonie and was preparing to include more Canadian dollars into their reserve portfolio. This wasn’t the first time that a foreign country had expressed a desire to do away with their US dollars. If other nations are looking to diversify into other currencies, then this doesn’t bode well for the dollar does it?

Rising debt. Low interest rates. Reserve diversification. Uh oh – what’s going to happen to the dollar?

So what do all these stuff above say about the dollar’s luck over the long haul? Will it be able to regain its prominence in the international currency arena? Will it be able to announce someday the words “Baby, I’m Back!”? Well, should the US economy move from recovery to growth then fundamental logic alone points to a “return” of the dollar. I mean the US has to progress sooner or later… right?

However, we all know that the market’s sentiment is more complicated nowadays. No longer does the positive relationship between fundamental economics and the currency’s value hold for the dollar. In fact, it’s totally the reverse. Risk appetite for higher yielding assets such as equities and non-dollar currencies grow in tandem with the economy’s growth. The opportunity for carry trades plus Russia and China’s threat of diversification add selling pressure on the dollar. And without the Fed’s support, the dollar can only go one way… down!

Could someone please dial 9-1-1?