Nervous about the falling dollar

Nervous about the falling dollar
http://archive.gulfnews.com/articles/07/10/06/10158300.html

10/06/2007 07:14 PM | Reuters

When does a gentle slide become a dangerous skid?

That is the big question as the dollar's decline gathers pace. The greenback fell almost two per cent against a basket of major currencies in the week after the Federal Reserve cut America's short-term interest rates on September 18, hitting a new low for the post-1973 floating era. The fall was particularly pronounced against the euro, where the dollar fell to a record $1.41 per euro on September 25.

Those nervously inclined see plenty of reason to fret. Some worry that central banks and other official investors may be about to dump dollars. Saudi Arabia's decision not to follow the Fed's lead and cut interest rates fuelled speculation last week that the kingdom was about to break its 21-year peg with the greenback. Others fear that a plunging dollar will fuel inflationary pressure in America and thus limit the Fed's ability to cut interest rates further.

In Europe there are worries that a stratospheric euro will imperil the region's growth. Nicolas Sarkozy, France's president, recently declared that the currency's rise above $1.40 was a "problem" for euro-zone competitiveness.

Some of this nervousness is exaggerated. With inflation rising in Saudi Arabia, the link to a falling dollar is causing a headache. A revaluation against the dollar or, better, a link to a basket of currencies - similar to the one Kuwait now has - would make more sense.

Commitment

But the Saudi government has denied that it plans anything of the sort. Its central bank governor repeated a commitment to the dollar peg on September 26. More important, a change in Saudi Arabia's currency regime - or that of other oil exporters - need not cause a dollar crash. Shifting to a currency peg does not mean a central bank would suddenly dump its dollar assets.

The inflationary risks from a weaker dollar are also easily overdone. Most economists reckon that the pass-through from a weaker dollar to higher import prices has weakened in recent years, and is particularly low in the US.

A new study by Robert Vigfusson, Nathan Sheets and Joseph Gagnon, three economists at the Federal Reserve, suggests that countries are more willing to absorb a rising exchange rate in their profit margins when exporting to America than when they export elsewhere, perhaps because they are keen to protect their share of America's huge market. Such a profit squeeze cannot continue indefinitely, of course, but as yet there is little sign that the dollar's weakness is aggravating price pressure.

For the moment, the dollar's decline is reflecting investors' expectations of Fed policy rather than tying the central bankers' hands. Financial markets increased the odds of more short-term interest-rate cuts last week after a barrage of grim economic news. The pace of home sales fell again in August; the backlog of unsold existing homes rose to ten-months' worth of supply; and consumer confidence plunged. As the gloomy economic news piled up, yields on ten-year Treasury bonds, which had risen on inflation jitters after the Fed's rate-cut, fell back.

Europe worries

Today's pessimism is centred on America - hence the tumbling dollar. But there may soon be reasons to worry about Europe. Germany's Ifo index of business confidence fell again last week for the fourth consecutive month, to a 19-month low. The aftershocks of the credit crisis coupled with a surging euro could make life difficult for Europe's firms.

So far, the European Central Bank has played down these risks and is signalling the likelihood of higher rates ahead. That hawkishness is part of the reason for the euro's rise. But if America's economy is truly in trouble, the outlook for the euro zone will darken too. America's currency will become others' problem.

- The Economist

Euro/dollar volatility will probably rise in coming weeks, while it will be lower for sterling/dollar and dollar/yen than it was over the past month, according to a foreign exchange poll.

The conclusion is based on the standard deviation of forecasts in the October currency survey, coupled with the actual levels of volatility seen last month. The poll implied monthly annualised volatility of 9.2 per cent for the euro against the dollar in October, up from the 5.3 per cent seen in September.

For the yen against the dollar, the poll suggested a volatility level of 9.3 per cent, lower than the 11 per cent actual volatility last month. For sterling against dollar, volatility was seen falling to 6.7 per cent this month from an actual 7.6 per cent in September. Analysts say the divergence of forecasts in Reuters currency polls offers a leading indicator of exchange rate volatility in the following month.

Statistical analysis suggests the more analysts' forecast divergence for a currency pair, the higher the actual volatility is likely to be in that currency in the following month.

Estimates of future volatility are used to calculate the value of currency options, which give investors the right to buy or sell a currency at a fixed price in the future.

As a measure of financial risk, the wider the expected trading range for a currency the higher the cost of purchasing an option to trade it.