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October 28th 2006

Commentary: USD correction continues to be postponed

In 1998, the Euro and the Britsh Pound began rallying against the USD, appreciating over 30% in the following years. Then, last year, the USD staged a miraculous comeback, retracing 10% of its losses against the world’s major currencies, and costing bearish US investors (such as Warren Buffet) billions of dollars in losses. This year, the Euro and the Pound resumed their upward path against the USD, but have been stuck in a narrow range for many months. And against the major currencies of Asia, the USD has performed equally (well), prevented from depreciating by what is believed to be deliberate intervention in forex markets.

This begs the question, that if so many fundamental economic indicators seem to favor rival currencies, why has the USD remained so resilient? The answers, of course, are complicated, and not readily apparent. The key to this puzzle lies in reconciling economic theory with financial reality. In theory, the laws of purchasing power parity and interest rate parity dictate that a country’s currency should move inversely with its interest rate and price levels. However, any financial economist will tell you that these laws will only obtain in the long run, if at all. In the short term, risk-averse investors flock to the countries that offer the highest real return on investment, which ensures countries with high interest rates will rarely see their currencies depreciate, as in the current case of the US.

In addition, the laws of economics are being artificially undermined by some of the policies of Asia, namely China, South Korea, and Japan. The economies of these countries are heavily reliant on exports, rather than domestic consumption. Thus, it is in their interests to implement any measures necessary to prevent their respective currencies from appreciating. These measures include issuing forex stabilization bonds, building up massive forex reserves, threatening markets with intervention, and maintaining unnaturally low interest rates to deter speculative capital inflows.

Purchasing power parity is being undermined further by the continued willingness of foreigners to finance the American twin deficits. The globalization of capital markets enables investors, worldwide, to seek out the highest returns on invested capital. This is directly preventing the USD from appreciating and the trade deficit from narrowing, since foreigners still prefer to invest in US capital markets, which are well-established, stable, and perennially strong. Unfortunately, the Federal Reserve Bank must contend with inflation and potential asset bubbles when conducting monetary policy; lowering interest rates would push the USD downward, but it might also drive core prices and asset prices up, which the Fed seems intent on avoiding at all costs.

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Posted by Adam Kritzer | in Commentary, Investing & Trading, US Dollar | No Comments »

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