NBK views on the US dollar

The US dollar hit new lows against major currencies last week as fundamental concerns over the currency dominate sentiment in currency markets.

With Treasury Secretary John Snow arguing that the decline in the dollar had so far been only 'fairly modest', investors are now convinced that the US administration wants to see the dollar fall in an orderly manner in order to help revive the US economy before next year's Presidential elections.

The G7 meeting last weekend resulted in no mention of foreign exchange markets in the formal statement, but US Treasury Secretary statement has confirmed what we have long believed - that the US 'strong dollar' policy has changed dramatically from the version the markets knew since 1995.

Similarly while Alan Greenspan gave a measured testimony last week to Congress on the prospects of the US economy, the market believes that the Federal Reserve will take all steps necessary to fight deflation. In a dis-inflationary US environment with a steep US yield curve, a lower dollar is helpful in generating more US and hence world economic growth.

US interest rates are too low and US asset markets too lackluster to sufficiently attract strong capital inflows back into the US and the current account deficit will stay high this year owing to the lags involved in exports responding to the weaker US unit.

In this environment many analysts continue to look for rallies in the dollar as opportunities to sell the currency, and look for EUR/USD to test the all-time high near 1.1900 before any meaningful consolidation can materialize. For as long as US government bond yields continue to trend lower it is safe to say that there will be few obstacles by the US monetary authorities put in the way of further dollar depreciation.

It is hard to reconcile a weakening currency with the notion that the US is entering a period of deflation. Deflation pushes currencies up, not down.

Therefore if deflation is not responsible for lower dollar, what is? Part of the answer is the fact that for every tick up in the EUR/USD rate, history tells us that US interest rates usually tick down. This is because the cheaper the US assets become in dollar terms, the more of them the market is likely to buy, hence pushing their prices up and their yields down.

This is a scenario the monetary authorities would welcome, hitting two birds in one stone - fighting deflation and boosting export-led recovery through lower dollar.

Therefore with US officials enjoying the perfect policy mix (weak dollar, low rates, loose fiscal stance), the incentive to meddle with foreign exchange variables is low. However, with euro having already rallied by 8% in the second quarter thus far, clearly much bad news on the US macro front has been priced in.