Baptism by fire looks like the operative phrase for describing the first order of business when Ben Bernanke succeeds Alan Greenspan at the Fed at the end of the month.
The central bank’s principal ward, otherwise known as the dollar, is looking increasingly ill as 2006 rolls on. As of Friday’s close, the U.S. Dollar Index shed 3.9% from the recent highs set back in November, with more than half of that loss coming last week. Adding insult to injury, gold is rallying again, pushing again to highs not seen in 25 years.

A leading explanation for the greenback’s stumble is the prediction that the Fed’s interest-rate hikes will soon end, thereby taking away one of the currency’s key means of support. One man’s forecast calls for Fed funds to rise to 4.75% in the near term from the current 4.25%. The man here is George Soros, famed hedge fund trader, as quoted by the Financial Times today.
Soros, who’s no stranger to currency trading, is hardly alone in expecting a conclusion to the Fed’s current round of monetary tightening. Whether he and like-minded speculators are right is another matter. If the dollar continues to weaken, Bernanke may feel the pressure to keep the rate hikes rolling for longer than previously expected.
In any case, the stakes are high for doing the right thing, and avoiding the opposite. Anticipating what exactly is right and wrong for Fed policy going forward will be difficult–more so than usual, courtesy of an approaching regime change at the central bank.
This much, at least, is clear: It’s no small advantage for the buck when its chief debt instrument, a 10-year Treasury, offers a yield premium of more than 100 basis points over its German equivalent (a euro proxy) or nearly a 300-basis-point edge over the yen-denominated 10-year from the Japanese government, according to Bloomberg data.
Even if the premium remains intact, there are other potential hazards to weigh when it comes to forex: Among the other suspects thought to be driving the recent selloff in the dollar:
* The demise of 2005’s special tax break for U.S. firms as per the Homeland Investment Act. As a result, the motivation for American multinationals to repatriate overseas profits and bring the money home, and thereby create demand for dollars, went the way of the Edsel on December 31.
* New reports circulating that China is finally getting serious about diversifying its vast holdings of dollar reserves (second in the world only to Japan’s portfolio of greenbacks) into other currencies.
* Renewed fears that the petrodollars building up in the coffers of the oil exporters are burning a hole in their collective pocket for seeking diversification into other currencies.
In second-guessing such events, real or imagined, yield clearly matters in the global market for assets. To the extent the dollar’s yield advantage wanes, it’s reasonable to expect some repercussions.
Rest assured, the Treasury’s yield edge isn’t going away any time soon. Short of a massive selloff in German or Japanese bonds, a new buying frenzy in Treasuries, or both, the spread won’t soon close in any great measure. But it will narrow; perhaps slowly, but narrow nonetheless. The relevant questions necessarily become: How fast will the spread narrow, and how will the markets react?
Anticipating said narrowing, the forex gods have deemed the dollar to be worth less today than in the recent past. What’s more, the revaluing of the buck is more than rank speculation. “The yen is finally trading in line with the strong Japanese growth and balance of payments fundamentals,” London-based Goldman, Sachs strategist Thomas Stolper wrote on Friday in a research note, according to Bloomberg News.
Meanwhile, optimism is on the march that Europe’s economic growth will advance at a higher pace than previously expected. Germany, the Continent’s largest economy, is said to be at the forefront of this upward reassessment. The government in Berlin was previously forecasting a 1.2% rise in the country’s 2006 GDP; that was raised last week to as high as 1.8%, according to German economy minister, Michael Glos via Deutsche Welle. “We’re sensing an upturn in the economy,” he opined.
Apparently, so too are forex traders, who increasingly are focusing on Japan and Europe’s growth prospects and America’s fiscal and trade deficits. It didn’t help that U.S. employment growth in December was weak, advancing a relatively shabby 108,000 for the month, down sharply from November’s more-impressive 305,000 gain.
To be sure, in the grand scheme of the dismal science, nothing has really changed today vs., say, last week or last quarter. America, for all its troubles, is still growing faster than its developed-nation counterparts while offering higher yields. It was a winning combination in 2005. But the potential ills that hover over the U.S. economy are no less potent today than they’ve been in the recent past. But that didn’t stop the greenback from delivering a sharp rally from 2005’s September through November.
Suddenly, that’s a distant memory. The danger in a fresh dollar selloff is that the momentum sparks something more than a quick selloff. Forex traders are by nature an anxious lot. Equity and bond traders the world over should now be wondering if a grand reversal of the buck is possible.