The U.S. dollar

The outlook for the U.S. dollar is closely tied to the outlook for carry trades. The main reason the dollar came close to recovering all its year-to-date losses this summer was the sharp stock-market sell-off pushed traders and investors back to cash, either willingly or unwillingly (because of margin calls). Everyone parked their money in U.S. dollars and the safety of U.S. treasuries.

Given the root problem is stemming from the U.S., this might not be the healthiest behavior. As the Federal Reserve begins to lower interest rates (reducing the dollar’s attractiveness), global investors will begin looking elsewhere for yield. At that time, the currencies that outperform the U.S. dollar will be those of countries that are still raising interest rates, keeping them steady, or lowering them far less aggressively than the Fed.

Also, if the problems in the U.S. exacerbate, a recession would be a big drag on the U.S. dollar. Unfortunately, the worst is not behind us. The credit squeeze could take a big bite out of corporate profitability by increasing the cost of borrowing. We have already seen a rise in layoffs and hiring freezes in many sectors of the economy. Financial companies will take the biggest hit: Many hedge funds and mortgage lenders have either filed for bankruptcy or closed up shop as a result of the credit and sub-prime debacle. The flight to safety should benefit the dollar in the short term, but the problems in the U.S. economy will catch up to it in the long term.