It looks as if today will be another difficult day for financial markets as AIG just announced the biggest loss in history ($61.7 billion for the last quarter of 2008). As markets in Asia and Europe opened with significant loses, the US dollar has climbed against all other major currencies. At $1.26 per Euro is back to the level it reached in November and December 2008 when financial markets were close to collapse.
What this crisis has shown us is that the US dollar remains the currency of choice for investors when panic reaches financial markets. Over the last months we have witnessed an interesting negative correlation between the daily performance of the US stock market and the dollar. In days where the stock market does poorly, the dollar tends to gain relative to other currencies, a sign that there is a flow towards US dollars when uncertainty increases and bad news spread.
The recent appreciation of the dollar stands in contrast to what we had seen in the run up to the current recession. The US dollar had depreciated heavily relative to the Euro and reached a minimum of about $1.6 to the Euro. The depreciation of the US dollar was seen as the way for the US to rebalance the deficit in the current account as imports became expensive and US goods improved their competitiveness.
It is interesting that after the crisis becomes evident in the Spring of 2008 and when the US current account deficit has not improved that much, the US dollar starts reversing course and appreciating. Also, this trend has been very much ignored by policy makers on both sides of the Atlantic. From the perspective of the US, the appreciation of the dollar at the time that the US government is engaging in a massive fiscal stimulus cannot help. Increased spending in the US will only help the US economy if it translates into purchases of US goods. If all the increase demand goes abroad, the rest of the world will be very happy but the fiscal stimulus will have limited effect on the US GDP.
Of course, one can argue that the current depreciation of the US dollar is bringing it back to “fundamental” levels (closer to what purchasing power parity tells us), but I am not sure the capital flows that are moving the exchange rate are motivated by these arguments.
How long will the US dollar remain the currency of choice in times of uncertainty? How long will foreigners be willing to hold US assets that pay a very low interest rate? There is no doubt that the future evolution of the US economy relative to other countries will be a key factor to answer these questions. Until then, and as we are seeing today, confidence and a long history of being the world reserve currency will determine capital flows and the value of the US currency in difficult and uncertain times.
Antonio Fatás
