Dollar for your thoughts

The dollar sold off in the last four months of 2004, and most observers expected it to decline further this year, with some high profile opinion makers even warning about a hard landing. Instead the greenback has appreciated against the major currencies, recouping much of the ground it lost in late 2004 period. (Perhaps the kiss of death was when Newsweek magazine ran the “The Incredible Shrinking Dollar” as its cover story on March 21.)

Many participants seemed to agree with Warren Buffett and Bill Gates, who publicly expressed concern about U.S. trade policies as a reason behind their decision to short the U.S. dollar. That there is a weak statistical relationship between a country’s trade balance and the performance of its currency has prompted others to shift their focus from the trade deficit to how the shortfall is financed.

Here, the monthly U.S. Treasury report on portfolio flows — Treasury International Capital, or TIC data— has become significant in the foreign exchange market.

All too often the market has focused on the role of central banks in financing the U.S. trade deficit. Judging from the TIC report, the role of central banks is often exaggerated. While foreign central banks are often buyers of U.S.

Treasuries and Agency paper, they account for a fraction of the demand for U.S. assets. In the first quarter of 2005, net private foreign purchases of U.S. assets totaled $764 billion, up almost 25 percent from the same period in 2004. The U.S. trade deficit has been over-financed thus far in 2005.

But perhaps the best explanation for the dollar’s unexpected strength lies with the shift in financial incentives. To put it simply, market participants are no longer paid to be short the U.S. dollar. The relative out-performance of the U.S. economy and the policy response by the Federal Reserve has translated into wider interest rate differentials between the dollar and other currencies.

A year ago overnight money was twice as high in the Euro-zone as it was in the U.S. It is possible that by the end of the year the U.S. will offer twice the Euro-zone’s rate. The spread on two-year T-notes is almost 140 basis points, the widest in five years. And the spread on 10-year T-notes is creeping toward 90 basis points from around 55 at the end of last year.