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Has Kohn Doomed the Dollar To Fresh Lows?

Last updated 10/14/2009 4:14 AM ET (GMT -5) 0 Comments - Add your comment

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Boris Schlossberg

Director of Currency Research, GFT

"I don't think a V-shaped recovery is the most likely outcome this time around," said Vice chairman of the Federal Reserve Board Donald Kohn in a speech to National Association for Business Economics last night, thus dooming the dollar to another round of selling as EUR/USD hit 1.49000 in overnight trade while AUD/USD reached a fresh new year high of 91.50.

"I expect the persistence of economic slack, accompanied by stable longer-term inflation expectations, will keep inflation subdued for some time," noted Mr. Kohn signaling that US rates are likely to remain stationary through most of 2010. It was those comments in particular that  weighed most heavily on the dollar during Asian trade.

Recent reports have highlighted the fact that global central bank reserve managers are allocating only approximately 33% of fresh inflows to dollar denominated assets. Most market participants have assumed that reserve managers are shunning the greenback because of capital depreciation risk  and while that is clearly a factor, we believe that their behavior is governed more by interest rate considerations rather than exchange rate fluctuations.

Reserve managers, much like all investors are responsible first and foremost for achieving yield on their assets and with short term US rates mired near 25 basis points for the foreseeable future, the return on their US fixed income investments remains minuscule at best. Thus, it is natural that central bank reserve managers whose interest is governed  by financial  rather than political concerns would seek to diversify into higher yielding currencies such as the EUR/USD and the AUD/USD.    

Given the fact that the highest yielding currencies in the industrialized world are the smallest economies within the G-10 universe, there is a limitation to how much capital reserve managers can commit to those  units. Therefore, although the European short term rates are only slightly higher at 1.00%, the EUR/USD has been the primary beneficiary of this trend  away from the dollar. Nevertheless, in the world of low yields the euro provides relative value both on the interest rate and liquidity basis and continues to attract investment and speculative flows.

Mr. Kohn’s cautious rhetoric stands in contrast to the more upbeat assessments recently made by Chairman Bernanke and St Louis Fed President James Bullard  and has now managed to sabotage any efforts by US monetary officials to stabilize the greenback through jawboning.  With EUR/USD within striking distance of the 1.50 barrier the temptation to run stops through that level will escalate as the day progresses. However today’s US Retail Sales numbers and FOMC minutes could offer a ray of hope to dollar bulls if they indicate that US economic environment is improving at a faster rate than currently projected, allowing the Fed to consider possible tightening actions in H1 of 2010.

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About The Author

Boris Schlossberg began his Wall Street trading career more than 20 years ago at Drexel Burhnam Lambert. There, he traded nearly every type of financial product on the market in the U.S., from equities and options to stock index futures and foreign exchange. His innate ability to analyze market information and use it to trade has helped him become an industry-recognized, “go to” trading professional.

These days, whenever the markets move, many organizations turn to Schlossberg for his take on the situation. He is a weekly contributor to CNBC's Squawk Box and a regular commentator for Bloomberg radio and television. His daily currency research is widely quoted by Reuters, Dow Jones and Agence France Presse newswires and appears in numerous newspapers worldwide. Schlossberg has written for publications like SFO magazine, Active Trader and Technical Analysis of Stocks and Commodities. He is also the author of Technical Analysis of the Currency Market and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Kathy Lien. He joined GFT in 2008.