Truth and Strong Dollar

The Malta Independent  

The Euro is flying on the foreign exchange markets and it has gone back and surpassed the highest level reached soon after its launch in January 1999. At launch it was around USD1.18 and went gradually to lose value reaching a bottom of 0.82 US cents late in October 2000. These days it has exceeded US1.19

It lost 30% against the USD in the space of 22 months and regained it all and more in the space of 30 months. These sort of wild gyrations cannot be driven by economic fundamentals. Fundamentals do not change so much and so quickly. It is almost entirely sentiment driven.

So the obvious question one should be asking is what drives market sentiment. That is indeed very hard to answer. It’s almost like asking what drives love – but not quite.

“I learnt that in politics it is dangerous to speak the truth.”

Sometimes sentiment responds in diametrically opposite ways to the same factors. In October 2000 when the dollar was touching its peak against the Euro the market was applauding the Federal Reserve for being more pro-active in cutting interest rates in order to stimulate economic growth which was evidently slowing down. The fact that the European Central Bank (ECB) seemed more obsessed with the risk of inflation and was prepared to sacrifice growth by keeping interest rates relatively high was given the thumbs down by the market so much so that the ECB had to intervene directly several times to support the Euro and avoid too drastic falls.

In contrast the market is currently pushing the Euro higher applauding ECB behaviour of keeping higher rates giving the Euro advantage of interest differential. The markets seem to have lost sight of the fact the economic growth in the Euro area is still very weak and that Germany is indeed risking falling into an outright deflation. Anyone who believes that a strong currency is the reflection of a strong economy is re-checking the text book

Obviously in the foreign exchange markets there are so many factors working on sentiment that it is unrealistic to take just one or two factors and marvel at different market reactions to the same set of circumstances. Other factors would be at work and in the current scenario one of the major factors influencing sentiment is the US government attitude for the USD.

Under the Clinton administration the US openly professed a strong dollar policy. Without doing much, the regular re-statement of this policy by Treasury Secretary Rubin was enough to keep the dollar strong on the foreign exchange market under-pinned by strong economic growth outperforming other regions.  

“ Whilst gaining popularity with the minority in the middle who want the truth and nothing but the truth, who are prepared to switch votes and probably determine the colour of the next government, there are just not enough of them around for the individual to achieve the success aspired for.”

The Bush administration continued to profess the same policy and with the Federal Reserve aggressively defending growth by regular interest rate cuts the market continued to give credibility to the strong dollar policy. Until gradually doubt started to enter firstly because the economic growth was not responding to interest rate cuts, secondly because the US Balance of Payments continued to build unsustainable deficit helped by the strong dollar policy, and thirdly because when tested the market found that the US administration was only prepared to give lip service to the strong dollar policy and would not intervene to support it when put to test.

What put paid to the strong dollar policy was Treasury Secretary Snow’s recent comment that the fall in the value of the dollar was quite modest. This is could be true considering that after all the dollar is back where it was in 1999 at the peak of Clinton’s growth cycle. But telling the truth is sometimes offensive to market sentiment that often prefers to continue living in a dream.

I learnt that in politics it is dangerous to speak the truth. Whilst gaining popularity with the minority in the middle who want the truth and nothing but the truth, who are prepared to switch votes and probably determine the colour of the next government, there are just not enough of them around for the individual to achieve the success aspired for. If Secretary Snow still believes in a strong dollar policy he should be more careful with the truth. If he no longer believes in a strong dollar policy he is doing just fine.