A contrarian perspective on the US dollar

Let us consider the course of the US dollar's value in the early years of the 21st century. The euro used to be worth less than the dollar at 80 US cents, now its value has risen to $1.27 at the time of writing this article.

Economists reckon that rather than tighten interest rates too far the Federal Reserve will continue with an easy money policy, at least in relative terms, and export the pain of adjusting the US economy to a huge trade deficit and foreign debts to Europe and Japan.

However, a contrarian might make several objections to this simple extrapolation. First, it is clear that the US dollar has already undergone 37 per cent devaluation and could it be that what experts are predicting is what has already happened? Certainly this is near the Fibonacci retracement level often seen in capital markets.

Safe haven currency

Secondly, as we saw in the Lebanon and Gaza crisis last week the US dollar is the international 'safe haven' currency in a crisis. In short, when capital markets sell off what do they buy, if only by default, US dollars!

Now if the global capital markets recent jitters - and the US indexes are now in negative territory for 2006 - are extended this autumn into more of a generalized financial crisis, and indeed some would say this is the kind of asset devaluation that you would expect to see follow a period of interest rate tightening, then will the sellers not end up as buyers of the US dollar?

This would doubtless lead to interest rate cuts to try to stabilize the situation, but capital markets do not usually march to rule and it could take some time before interest rate cuts stimulated a recovery. In the meantime, a large amount of funds will stay in US dollars, supporting the value of the same currency.

In fact, an overvalued US dollar might become a severe hindrance to the recovery of the US economy from an asset price correction because of its status as a 'safe haven' and 'reserve currency'.

Central banks

Contrarians would also note that central banks are just starting to talk about seriously diversifying away from the US dollar. Central bankers have an appalling record on market timing - selling off gold just before the recent price rises, for example - and take so long to form a consensus that it may be overtaken swiftly by events.

Another thought to consider is that if the US dollar devaluation of recent years has exported its economic weakness to Europe and Japan then these economies are going to collapse first if the global economy weakens, so how could the dollar devalue even more against their currencies?

It does not make sense: the dollar has to devalue against something in order to devalue; and which economy do you think has the greatest long-term strength, the US, Japan or Europe? So diversifying your US dollar holdings now, with the dollar already on the floor, might not prove to be such a bright idea.