Just about everyone thinks European currencies and the Japanese yen are hugely overvalued against the U.S. dollar at present levels. Goldman Sachs, for instance, says its "fair value" measure for the dollar against the euro is $1.21, not today's $1.56. But many analysts now think that in the next few weeks the dollar could be hit with yet more declines.
Many factors are working to undermine the dollar, from stronger economic performance in other countries to disturbing events such as the Mar. 14 rescue of beleaguered investment bank Bear Stearns. While the decline has not yet spiraled out of control, analysts such as London-based Morgan Stanley economist Stephen Jen are beginning to sound the alarm about "the wholesale erosion of confidence in the U.S. dollar and dollar assets."
The U.S. and European economies and their central banks are clearly out of sync. Federal Reserve Chairman Ben Bernanke is actively cutting rates and stressing the danger of a sharp fall in economic growth, while his European Central Bank counterpart Jean-Claude Trichet is not only resisting cuts but showing greater concern about the dangers of inflation, though he did recently lecture the markets about "excessive exchange rate moves."
This standoff arises partly from differences in mandate. The ECB's writ is to fight inflation, while the Fed is charged with maintaining growth and employment. But another key difference is that the U.S. economy is now widely assumed to be mired in a recession. The U.S. financial system also looks increasingly shaky, as evidenced by the Bear Stearns bailout.
In contrast, Europe still looks relatively healthy—so the euro and euro assets look a safer play for investors. "Growth in the euro zone has clearly moderated," says Barclays Capital currency analyst David Woo, "but we have not seen anything like the synchronized slowdown during previous episodes of major U.S. slowdowns."
A "vicious circle"
The differences in economic performance and the prospect of deeper rate cuts in the U.S. favor the euro. But there are other more worrisome factors weighing on the ailing greenback. Jen of Morgan Stanley detects a "vicious circle" that is being fueled by the combination of the weakening dollar and rising commodity prices. The dollar/euro exchange rate and the price of oil and other commodities have become very closely correlated, as investors shovel money into oil, industrial metals, and grains for their apparent safety.
This relationship has looked particularly tight in the last few days, as oil prices soared to $1.10 per barrel and the dollar slumped to $1.56 on the euro. This dynamic, largely driven by financial speculation, is "making the world think that there is more inflation than there really is," says Jen.
Indeed, fear that inflation is rising is probably making central bankers like the ECB's Trichet even more resistant to cutting rates—even though it is hard to see how national or regional interest rates will affect the price of grains or oil, which are set globally. Moreover, the growing perception that stagflation is taking hold in the U.S. is also undermining confidence in the Fed, by making it look ineffective on inflation (BusinessWeek.com, 3/13/08).
That also hurts the dollar. Says Woo of Barclays Capital: "The aggressive Fed easing and the continued dovishness of Fed officials, which have no doubt contributed to the sharp rise in commodity prices, have probably made the ECB even more reluctant to cut rates and more ready to tolerate a strong euro"—which acts as a price stabilizer.
The danger is that the dollar slide becomes a panic, sowing havoc in world markets. One big blow to confidence could come if Qatar or the United Arab Emirates abandon their currencies' peg to the dollar—a move they are considering. This could create fears of a wholesale shift of petrodollars and sovereign wealth funds out of the greenback. With worry about a dollar rout growing, the markets also are turning their attention to the prospect of some sort of coordinated intervention. A move by the Fed, the ECB, and the Bank of Japan, perhaps joined by such new heavyweights as China and Saudi Arabia, may be needed to convince the markets that enough is enough.
But most signs are that such a step is not imminent. The Bush Administration shows little interest in abandoning its faith in markets and its aversion to financial intervention. The ECB still has reason to consider an inflated euro benign. Until there is more of a meeting of the minds, the dollar may continue to take a beating — or worse.