from Follow the Money

Is bad news for the world good news for the dollar …

July 20, 2006

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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I have long been puzzled by the notion that the currency of a country with a 6% of GDP trade deficit and a 7% of GDP (maybe a bit less in q1 … ) constitutes a “safe haven.”   Safe havens are supposed to have rock solid financials.  And it is pretty clear to all but the true believers in dark matter that the US dollar has to depreciate (particularly against the currencies of the emerging world, not a relic index like the DX) at some point to reduce the US trade deficit.   

I suspect Bankim Chadha and Jens Nystedt of Deutschebank (full disclosure: Jens is a friend from my DC days) are also puzzled. 

They decided to test the proposition that the dollar is a safe haven during times of stress (no link because it DB prop content).   They defined stress as equity market volatility.  Obviously, there are other potential definitions of stress.   

But the logic behind testing for a correlation with equity market volatility is pretty straight forward.   Equity markets tend to be correlated, and the US equity market tends to be less volatile than most. 

It turns out that there is a correlation between equity volatility and dollar moves (on the Fed’s index) in the daily data – at least over the past ten years.    That makes intuitive sense to me.    The big fall in dollar (02-04) came during a period when equity market volatility was generally declining.  And the big rise in the dollar (95-02) came during period when there was a fair amount of volatility.

But Chadha and Nystedt didn’t stop there.  They looked further back – way back.  And they discovered this effect is a rather recent phenomenon.   During past periods of adjustment, equity volatility wasn’t good for the dollar …  

They expect things will change going forward.  The correlations that accompanied the period where the US trade and current account deficit were growing shouldn’t be projected out.  Different correlations may come to the fore when conditions differ.

That is interesting, at least to me.  Maybe because it is consistent with a lot of my thinking.   I have long worried that there will be a break in the tendency for US interest rates (long-term ones) to fall when US growth slows.    

Why – because in the past, US investors dominated the bond market.  But now, a very large share of US treasuries are held abroad.  That already seems to be changing sold old rules of thumb.  After all, the recent period of strong growth hasn’t pushed rates up – certainly not ex post real rates.  Nominal rates have drifted up, but still aren’t that much higher than backward looking CPI inflation.    That does cause the US any pain.   But the US should at least worry about the possibility that a slowdown that leads the fed to push short-term rates down would generate fears of dollar weakness that would lead America’s foreign creditors to demand higher rates on their long-term debt.  Things that generally were true when foreign savings were  small relative to the US market may not prove true in the new age.

But predicting changes is hard – and predicting the timing of changes is even harder. 

A related question – one for another time – are high oil prices good or bad for the dollar.  I can see both sides of the argument.

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