The U.S. dollar: Too big to fail?

August 31, 2009 07:00 PM

Economic recovery and risk appetite are the two major themes affecting today’s currency markets. After creeping up and almost reaching 90 in March 2009, the U.S. dollar index dropped back down to under 80 at the end of July. How fast the U.S. economy will recover from the economic implosion of 2008 likely will determine how fast the dollar will recover and influence where other currencies go in 2009 and beyond. But analysts say that with recovery comes increased appetite for risk, which could cause investors to move out of the relative safety of U.S. dollars.

“The fundamentals are improving, but positive U.S. fundamentals are bringing risk appetite to the market, which would drive the euro and pound,” says Dan Cook, senior market analyst for IG Markets.

Mark Frey, vice president for forex trading at Custom House, says the market is overwhelmingly focused on the interplay between risk acceptance and risk aversion, with any new rounds of risk aversion benefiting the U.S. dollar as a flight to quality play.

Kathy Lien, director of currency research at GFT, says dollar weakness is the predominant theme in the currency market for the second half of 2009. “The dollar is off so aggressively because risk appetite has improved. Everyone is looking to a potential recovery in the U.S. and all other countries in the fourth quarter into 2010,” she says. Proof of this is the dollar’s inverse relationship with equity markets for most of 2009 (see “Good news bad for dollar”).

Brian Dolan, chief currency strategist for GAIN Capital, says there is tremendous incentive for all G20 economies to limit the extent of dollar weakness and the strength of their own currencies. “The stronger their currencies get, the more delayed recovery is going to be in their own economies. All of the interests line up to put a floor under the dollar.”

Analysts say one reason for the weakness in the dollar is the record budget deficit in the United States. The Congressional Budget Office’s estimated U.S. budget deficit for 2009 is $1.18 trillion. It projects that the deficit will go down in 2010 and beyond (see “Far behind”). Those projections appear rosy to some, and will need to be met to support a dollar recovery.

Andrew Wilkinson, senior analyst at Interactive Brokers, notes that a big deficit could make the cost of borrowing increase, which he says could turn the economy “into the gutter.” “You have to watch what’s going on with the deficit and the currency market and interest rate market’s perception towards the dollar in terms of the deficit,” he adds.

“The deficit concerns undermine the dollar, but those concerns are going to be addressed. As growth begins to recover, the deficit picture will begin to improve, but it’s going to be a long road,” Dolan says.

President Obama’s economic stimulus plans could be a drag on the dollar. “How aggressive [will] the Obama administration be in [tightening] the purse strings? They’ve shown very little restraint at this point, and that’s been accepted by most financial market analysis as the right policy to take. If they keep spending while the economy begins to improve, that could be a dollar negative,” Frey says.

Lien agrees. “The dollar has been weakening because of the stimulus programs and the quantitative easing that the Obama administration has announced. The health care plan is estimated to cost $1 trillion, and in order to pay for that plan the U.S. government will either have to raise taxes, print more money or borrow more. All three of those are going to be dollar negative,” she says.

Traders should pay attention to what central banks are saying about their fiscal policy to predict where currencies are heading next. Most analysts do not expect any of the major economies to raise interest rates until 2010.

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