Dollar Drop Reducing Fed Need

The Federal Reserve's traded-weighted dollar index reached a new low last Friday and has hovered there ever since. The previous low dates back to the origin of the index in 1973.

The Fed's index is superior to the more widely followed U.S. dollar index that trades at the New York Board of Trade (NYBOT) division of ICE Futures. The NYBOT index is based on only six currencies. The Fed index is also likely more widely followed by the Federal Open Market Committee.

The Fed's index closed Wednesday (the most recent date available) at 73.58, posting a decline of about 5 points in two months. Since the start of the year, the index has fallen 11.6% following a decline of 5.2% in 2006 and an increase of 8.2% in 2005.

The recent decline is notable and fits with a theme I've expounded since 2006: Central banks are diversifying their portfolio assets out of dollars into other assets, including gold and other currencies. This is clear in Japan's net selling of Treasuries over the past three years, which accelerated in August with a sale of $24.8 billion in Treasuries.

The diversification theme is also apparent in the most recent data on international capital flows, which showed that foreign investors were net sellers of a record $69.3 billion of U.S. securities in August.

One important implication of the dollar's drop relates to the outlook on Fed policy. Some studies have shown that a 2.5% decline in the value of the dollar can have the same economic impact as a 25 basis point cut in interest rates. This theme will be apparent next Wednesday when GDP data is released. This will show that export growth helped keep the economy afloat during the quarter, as it did in the previous quarter.

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Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of the revised investment classic, The Money Market, first published in 1978 by Marcia Stigum, and The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback; click here to send him an email.

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