Dollar's fate directly tied to projection of US growth

A popular saying (attributed to Teddy Roosevelt) says: "Speak softly and carry a big stick; you'll go far". Perhaps that applies in matters of foreign affairs. In matters of foreign exchange markets, however, the Obama administration seems to have taken a converse perspective: "Speak loudly and carry no stick."

To be fair to the administration, every American government has always talked up the dollar. To do otherwise would be an implicit signal to the foreign holders of US Treasury bonds to abandon dollar-denominated debt. It would not be uncharitable if one were to describe a "strong dollar" policy as nothing more than a figure of speech.

The fundamental reason is that American policy makers seemed to have understood that if you get the macroeconomic basics right, then the dollar will take care of itself.

However, the past decade has been a policy blur. A terrible hangover continues! In this environment of obfuscation by the administration, the first thing is to understand the underlying theoretical constructs that govern foreign exchange. It is also useful to remember, a priori, that foreign exchange rates are about relative values, about the relative change in perceived exchangeability of goods and assets between country A and country B:

So, in the forex markets one must think about the following four "relative" truths: (i) relative growth between economies (ii) relative tightening of monetary policies (iii) relative arbitrariness of the central banks and (iv) relative over-valuation of currencies.

The fundamental driver of a forex rate is the foreign demand of domestic goods and assets. As demand increases for country A — the inflation adjusted exchange rate (called real exchange rate) appreciates. This appreciation can happen through two channels — price rises in country A and/or through appreciation of the nominal exchange rate.

Nominal exchange rates are those you get at currency exchanges. So if the central banks are targeting inflation rates and raise interest rates to keep prices under control, then nominal exchange rates will rise in the face of external demand rising. Instead if rates are flat (and no nominal appreciation), then inflation will emerge. In essence, there is no way around this relationship except for intervention in the forex markets (which results in its own dynamic of increases-decreases foreign exchange reserves in the central banks).

Interventionist

Typically, central banks of emerging markets tend to be more interventionist in the forex markets. More often, growth (via exports) is more important than inflation. Think of China's artificially low yuan-driven economy. In contrast, in developed economies, the central banks over the last 30 years tend to be hawkish about inflation than their emerging market peers. So any implied trajectory of forex rates is relatively more reflective of underlying economic climate than pure policy biases that skew the true economic climate.

Viewed in this framework, two things stand out. As the economic climate improves in the rest of the world and in the context of rising South-South trade (trade between emerging markets), the central banks of India, Brazil, etc, are faced with the prospect of increased demand.

Given the liquidity pumped into their economies in the wake of the credit crisis and prospective supply shocks involved, the central banks are more than likely to let the real exchange rate appreciate via a rising nominal exchange rate rather than inflation.

What this means for the dollar is clear: further dollar depreciation in the months to come across the entire major and some emerging market currencies.

It is useful to remember that exchange rates have a tendency to substantially over- or under-shoot — as Rudiger Dornbusch showed in the 1970s — from an "equilibrium" price.

The fate of the dollar is thus directly tied to one's projection of US economic growth. As noted in a previous column, with rising inventory orders and increased infrastructure, spending is likely to improve bottom-line growth of the US by the middle of 2010.

So the increasing consensus among currency watchers is that for the time being the dollar is likely to be volatile and depreciate excessively. But a rebound is inevitable by early 2010. The great unknown in this equation is the possibility of a catastrophic collapse of the Baltic banking system in the days ahead a la Iceland-Ireland. Such an event would impose upon European central banks pressure to step in and bail out — resulting in a weakening of the euro — and reallocation across global portfolios.

Currency markets love biases, as 2009 provides. In 2010, however, one might have to wonder about the idea of dollar dominance, as Shakespeare writes in King Lear, "Is this the promised end?"

The columnist works for a major European investment bank in New York City.