Future gazing: strength in US dollar in the short term (Part II)

By Atim Kabra

In my previous post, I discussed the fundamental underpinnings which would lead to a weakening dollar in the medium term. This is expected to happen though when stability returns to the markets - be they financial, foreign exchange or commodities. Moreover for the dollar to start weakening, clarity on the fate of Euro zone economies is critical. As it stands today, in the short run, US dollar is perceived to be the currency of choice.

Interestingly, the dollar is strengthening at a time when it is clear that the fundamentals of the US economy are deteriorating. The very pillars of financial strength and leadership in the areas of politics, high end financial services, manufacturing and R&D which gave the US dollar its underlying strength and resilience are shaky and no longer the sole hegemony of USA. The collapse of the unfettered laissez- faire Capitalistic system has Europeans and Chinese gloating over their version of Capitalism adulterated with Socialism in various degrees. The European Union under the leadership of a rejuvenated France is offering a non confrontational yet nuanced counter vision to the American world view. On the Industrial front, the Chinese are increasingly moving up the ladder of R&D driven manufacturing processes while the Japanese, Taiwanese and the Koreans continue to chip away the American dominance in high tech in their areas of expertise.

Then what is driving the US dollars strength in the short term. It is a combination of the following:

A transparent & self cleansing US Capitalistic system: The faith in the US system's inherent ability to cleanse itself at a faster pace than others is reassuring to the investors. It is a process driven to a large extent by transparency of the Financial Institutions now that they are under a scanner. The pace at which the US government has reacted to the crisis and the bipartisan manner in which both the Republicans and the Democrats have rallied around the Treasury's efforts to find a solution has also worked to soothe investor nerves to an extent. It is reassuring to know that the entire might of the US government is at work trying to ease the crisis though the overwhelming view at this point in time coalesces around a prolonged economic slowdown. . I have been speaking to a whole range of financial players and the investors appear to be more scared of the dangers emanating from opaque holdings of various European banks than the relatively known problems of the Americans. It is no secret that European banks were significant investors in rated bundles of US mortgage securities, smug in the belief that the high yields were seemingly secure by the investment grade stamps provided by the various rating agencies. Now that the ratings have been rendered impotent and the value of the illiquid securities is plummeting with no buyers around, these banks will have to take huge write offs. Barclays, RBS and Lloyds have each sought $26bn to strengthen their balance sheets while almost all European governments have sought to guarantee investors deposits to shore up the faith in the banking system. A flight from Euro in such a scenario works in favour of the Dollar.

Worsening European Economies: The fast deterioration in the European economies is unnerving investors globally. Sustained interest rate cuts in the Euro zone are on cards in face of the worsening economies thereby dimming the returns on the Euro. The Central banks across the North Atlantic are flooding the system with liquidity, as spooked lenders refuse to lend sparking a severe credit crunch all across. Short term commercial paper is finding no takers shutting off the spigots on a critical short term financing instrument.