What the Dollar Bounce Does Not Mean

The Treasury's monthly portfolio investment flow report, the Federal Reserve's weekly custody holdings and the government's quarterly balance of payments report, which captures other portfolio flows and dierct investment, all concur that U.S. capital account surplus is more than enough to cover the current account deficit.

Recently I met with more than a dozen asset managers in Tokyo. My far-from-scientific survey confirmed what the newswires have picked up, namely that life insurers are not too enthusiastic about U.S. Treasuries. But the significance of this observation is the real issue.

Consider gold. It will be readily recalled that the Bretton Woods system of fixed exchange rates was toppled by a few European allies of the U.S. demanding gold for Treassury obligations at a rate that was too great for the Nixon administration. Twenty-five to 30 years later, lo and behold, the Europeans say they have too much gold and have been engaged in an orderly liquidation of a large part of their holdings. And what has gold done in the face of these official sales? Rally, of course, until very recently.

The anticipation and reality of the Federal Reserve being on hold is a necessary but insufficient condition for a strong dollar rally. More developments are needed. These, I think, include evidence that the enormous monetary and fiscal easing (with nearly half the federal checks to be mailed this month) will support the economy. And frankly, this remains in the realm of hope still. Many won't be convinced that the economy has turned until the housing market stabilizes, and this too is not at hand yet..

Developments elsewhere are important too. The ECB has backed away from harsh rhetoric that had sent the euro above the $1.60 level, and this clearly helped take the steam out of it. Yet ECB still appears to be willing to sacrifice the economy for the sake of its inflation credentials, though it has overshot its self-picked and defined inflation target consistently for nearly a decade.