The outlook

The last global crisis was the result of a lack of common sense on the part of the geniuses at Long Term Capital Management, who failed to understand that panic doesn’t discriminate between valid targets and everything else in its path.

This time the initial response was a flight to the U.S. dollar, even over the traditional safe-haven Swiss franc, followed a dollar crash . The Swiss franc rose from a low of 1.5277 on July 9, 1998 to 1.2804 by Nov. 8, 1998 — a 16-percent move that was far more than could be attributed to Fed rate cuts at the time. It was dollar revulsion, plain and simple.

Look at how the dollar is behaving today vis-à-vis the euro now. The chart is labeled “worst case” because it makes some extreme assumptions. Let’s say the current flight to dollars has prevented the euro from rising to the level it was headed for since bottoming in November 2005 at 1.1673. In fact, the euro is actually under the long term linear regression trend line, which begins at the all time euro low of 0.8246 in October 2000. It took more than three years for the euro to reach its first cycle high at 1.2633 in December 2004 — a gain of 5,400 points.

Projecting another 5,400-point move from the intermediate low of 1.1673 during the week of Nov. 18, 2005 gives a reading of 1.7073, which is outside the linear regression channel.

But it’s not necessary to make such an extreme forecast. The extended linear regression trendline (dotted line) gives a reading of 1.4050 by year-end this year and 1.4735 by yearend 2008. Prices never move in a straight line, of course, and events can develop in Europe — and Japan — to create discouragement over the euro. But the hand-drawn red trendline indicates the euro has support from about 1.3400 today and rising to the linear regression trendline by the end of next year.

The only reason to suppose this crisis will play out any differently from the one in 1997-98 is the character of Fed chief Bernanke, who desperately wants to avoid engaging in a “Greenspan put” — cutting rates willy-nilly, at the cost of moral hazard. But he will probably have no choice. This is a bet-the-ranch moment.

The extreme outcome is not the only possible outcome, of course. The U.S. and the dollar weathered the S&L debacle in the 1980s, Long-Term Capital in the 1990s, and Enron and WorldCom in the first years of the 2000s. But the U.S. economy is robust, markets are adaptive, and financial institutions are well-structured. No one thinks the current crisis will bring down a pension fund, for example. It’s conceivable that gridlock is cured and panic in multiple markets is damped down long before those poisonous mortgage rate resets come to pass. But in currency trading, anti-dollar sentiment is the devil to reverse. Traders rejoice in clear trends with obvious “causes.” Sentiment is asymmetrical — bad news is proof and good news is brushed off. We will not be buying dollars any time soon.