Investors may worship money but their love of the dollar can be fickle. Sure it has been the reserve currency of choice for decades, thanks to the size and competitiveness of the US economy. A couple of years ago, however, its pre-eminence came into question, with supermodels refusing to get out of bed for anything other than euros. Then along came the credit crunch and investors fled back to dollars. Now, once more, the dollar is becoming increasingly spurned.
In the short term the dollar looks to be trading as a safe-haven asset. Indeed, Barclays Capital demonstrates this by analysing the risk premium investors have demanded for holding dollar assets since the beginning of 1999. Looking at the dollar versus the euro, this premium, or excess return, is defined as the interest rate differential between the US and the eurozone consistent with investors being indifferent between dollars and euros. The results show that in times of crisis a lower premium is required to own dollars whereas in calmer periods, around 2006 say, investors demand an excess return of up to 100 basis points. That suggests a weaker dollar if and when the economic crisis abates. Indeed, just as optimism has grown since stock markets troughed in March, so has the trade-weighted dollar fallen by 11 per cent. Of course, things could turn for the worse again. That would support the dollar, although trading could be choppy depending on actions by the Fed, particularly regarding quantitative easing.
Longer term, however, it will be a combination of US fiscal and monetary policy that determines the fate of the dollar. Usually, a strong dollar has coincided with relatively stronger government finances versus eurozone economies or relatively tighter monetary policy, or both. But there's the rub. The US will have low rates and a terrible fiscal position for years. Yet so will everywhere else. Investors may have to love the dollar a while longer.