What a Week: Dollar Dilemma

Several trends are responsible for pushing the dollar over the edge this week, including foreign central bank diversification out of dollar assets. Earlier this month, the People's Bank of China Governor Zhou Xiaochuan said the central bank planned to diversify out of U.S. dollar assets, and his words echoed those of other central bankers in the Middle East, Russia and Switzerland.

Indeed, foreign dollar reserves have hit the high-water mark at many central banks, writes Tony Crescenzi, chief fixed-income strategist at Miller Tabak and a RealMoney.com contributor. In late October, China's dollar-denominated reserves topped the $1 trillion mark, up from around $200 billion from 2001. Russia's reserves are about $270 billion, compared with $10 billion in 1998.

Foreign central bankers understandably worry that holding too many dollar assets puts them in danger if the dollar were to decline sharply. But they walk a fine line as their export-driven economies are supported by a not-too-weak dollar. On the other side of the trade, the U.S. needs foreign investment in dollar-denominated assets, most notably Treasuries, to finance its massive trade deficit, which declined in September, but remains at near record levels at $64.3 billion.

Treasuries rallied Friday, once again revealing traders' sanguine view of the foreigners' diversifying story. The 30-year Treasury bond rallied 9/32 Friday to yield 4.63%, down from 4.69% last Friday (bond prices move inversely to yields). The 10-year note added 4/32 to yield 4.55%, down from 4.6% last week, and the two-year gained 1/32 Friday to yield 4.73%, down from 4.76% last Friday.