Friday, June 17, 2005

$, £ & Euro - It's All About Confidence

The financial MSM says that exchange rates are driven by economics ("Twin Deficits, etc). But the numbers say that the value of a currency is determined by how safe it feels to investors, relative to the others. Which, in my view, means that the $ and £ will trend up and the Euro down.

Joel Kurtzman develops this theory.

Since 1971, the dollar has had no real-world backing other than the level of confidence the rest of the world puts in the United States and in its future. Interest rates play a part, but people are willing to forgo a basis point or two of today’s returns if they believe tomorrow’s yields will be even better.

With regard to confidence in the United States, there have been ups and downs. The dollar sagged under Carter, rose under Reagan, fell under the first George Bush, rose dramatically under Clinton and lost 40 percent of its value under the second George Bush.

The recent dramatic fall in the value of the dollar has led to slower global growth, higher oil and commodity prices, tensions with China and increased inflationary pressure.

But confidence is relative and the question most people ask themselves when they do their analysis is, “if we can’t rely on the US, who can we rely on?” In the run up to the war in Iraq, the financial world put faith in Europe and in the euro.

Money managers liked what French President Chirac and German Chancellor Schroeder said and grumbled about Bush. Financial leaders thought Europe had moxie and its leaders weren’t afraid to chart their own way.

But as the vote over Europe’s cumbersome and lengthy constitution began to look more like a “non” than a “oui,” the world realized that on a bet on Europe was a far more uncertain than a bet on the US.

With confidence in Europe’s future waning, the all-mighty euro began to lose altitude. On the day French voters turned against the constitution, the euro lost 2.5 percent of its value against the dollar.

With Europe’s pro-constitution leaders off licking their wounds, Chirac’s vision of Europe as a second superpower is still a long way off. As a result, there will be no European “counterweight” to US power in the near future, and perhaps never.

None of this, of course, has been lost on the world’s financial leaders. As a result, we are beginning to see a recovery in the value of the dollar, despite falling US interest rates. In my view, the dollar has entered into a long term upward trend in value against the world’s other leading currencies.

So today, in spite of the US announcing a record deficit, the $ moved just 1c. Which is good news for the Euro nations, because a weaker euro means that their exports cost less, so their messed-up economies should improve. Of course their imports cost more, but that's life.