Dollar Keeps Riding High, Despite Recent Events

One month after the terrorist strike on the U.S., the dollar has fully recovered and is poised to break higher. Frankly, it is not easily explained, and it runs counter to our fundamental view that the events of Sept. 11 would negatively affect the economy -- including depressing consumer sentiment, business investment and corporate earnings -- and drive the dollar lower (more vs. the European currencies than the yen). Keep in mind these factors helped send the dollar down about 8% on a trade-weighted basis from its 15-year highs hit in early July.

What, then, is different that explains a higher U.S. stock market and rebounding dollar?

Perhaps the most compelling observation, if not cause for the higher dollar, is simply how little dollar-selling was seen in the wake of the Sept. 11 disaster. On the day of the disaster, the dollar fell about 2% and had trouble sliding further in the next four weeks, despite a two-week shutdown of U.S. consumer spending, a transportation system grounded for several days, forced closure of the stock and bond markets, nervous Federal Reserve easing ahead of the stock market reopening, failed Treasury trades due to damage to the settlement system, U.S. retaliation and numerous additional terrorist scares -- not to mention the single worst day for the U.S. arguably in its history.

Perhaps it is the images going out to the world of the U.S. coping with the Sept. 11 attack. National unity has not been higher. The resources marshaled to cope with the New York City rescue and cleanup are mind-boggling. Even Congress moved quickly to provide funds to New York and will soon move again on fiscal stimulus ($100 billion in all).

Compare this with the routine situation across the eurozone: Budget deficits are the rule, and the scope for fiscal stimulus is near zero without throwing in the towel on Stability Pact criteria. Compare the Fed and the European Central Bank: ECB President Wim Duisenberg continues to imply that the Fed is too activist and the European Central Bank will never be that active as long as policy is anchored by a single mandate of price stability. He may ultimately be right, but Alan Greenspan's Fed has the track record that investors prefer. The emerging global economy demands flexibility and, in times of crisis, risk-taking. In a crisis, we will take Greenspan every time.

The World Still Looks to the Dollar

The point is that the global financial system is dollar-centric. The dollar is still unchallenged as the world's reserve currency. And the global economy and financial system are highly codependent; the center of gravity in this universe is the U.S. Neither an unimaginable terrorist attack nor a recession will alter this alignment. Perhaps the question we should be trying to answer is where will the euro trade if there is a recession in Europe or, God forbid, a terrorist strike in Paris, Frankfurt or Rome? Or the better question is why aren't the euro, Swiss franc and sterling much higher?

The lesson here is that the euro did not put in a long-term bottom in early July.

And the yen? New physics are required in analyzing this currency. If the world economic system stopped functioning tomorrow, the dollar/yen would still be 120 bid, 121 offered. Between intervention, seasonal flows, captive domestic savings, risk-perverse investors in Japan, limited foreign-investor interest in Japanese assets and a balance of payments surplus, the yen dances to its own drummer. Few will disagree that it should be more than 150 per dollar in the current environment using traditional analysis.

Three recessions in a decade and another one widely discounted currently, and the dollar/yen has not been above 150 in more than 3 years. The distortions in the Japanese real and financial markets are incomprehensible. It should be lower -- and even lower vs. the euro. But if we have learned anything about the yen in the past decade, it rarely does what it is supposed to do. Look for 130, gradually.

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