Disorderly dollar fall could damage Treasuries


By Burton Frierson
Wednesday, August 8, 2007


NEW YORK -- The U.S. Treasury market could suffer if the dollar's fall accelerates dramatically or becomes inflationary, though the dollar's orderly decline this year has yet to unnerve bond investors.

The greenback has fallen against the euro, Canadian dollar, British pound and other currencies, but there has been little lasting effect on U.S. government bonds, especially with investors transfixed by the shakeout in stocks and other risky assets.

Treasuries have gained from investors' flight to quality, inspired by tightening conditions in the corporate and mortgage lending markets, overcoming concerns of a weak dollar fueling inflation or causing an investor stampede out of U.S. assets.

The latest U.S. government bond rally came as the dollar fell to 15-year lows against a broad basket of currencies, suggesting the greenback's decline would have to accelerate to gain the attention of fixed income investors.

"I don't think we are at a point where the dollar is weak enough that it independently has a strong impact on Treasury rates," said Jerry Webman, senior investment officer and chief economist at Oppenheimer Funds in New York.

"At some point there is a level at which the dollar is plummeting and nobody wants to own dollar-denominated assets, but we are quite far from that," said Webman.

Fixed income analysts were reluctant to pick levels that would trigger Treasury selling, but foreign exchange traders are eyeing any move below the dollar index's all-time low of 78.19. That level would focus investors more closely on the potential for the greenback's slide to accelerate into an inflationary rout.

For now, price action indicates interest rates are driving the currency, not the other way around. This is business as usual in the yield-driven foreign exchange market.

As U.S. economic growth slowed this year, it accelerated elsewhere, causing investors to position for higher euro zone interest rates, for example, while the Federal Reserve was expected to hold borrowing costs steady or even lower them.

As a result, the dollar's interest rate advantage over the euro zone, measured by the difference in 10-year government bond yields, narrowed by more than 30 basis points even before the latest credit-inspired rally in Treasuries.

The gap narrowed further on expectations recent financial market ructions would weigh on growth and lead the Fed to ease. The dollar has also racked up losses during that time, but investors clearly did not sour on Treasuries, which rallied.

"It's a bit of a short-sighted view that because the dollar is weaker therefore that is a bearish element for Treasuries," said David Ader, head of government bond strategy at RBS Greenwich Capital in Greenwich, Connecticut.

"Of course it's inflationary and of course it may make dollar-based assets weaker, but on the other hand it makes dollar-based investments cheaper for those who haven't bought."

Still, few things would spark a Treasuries sell-off quicker than a dollar-driven inflation scare, particularly since the United States depends heavily on imports.

The U.S. trade deficit, reflected in the current account balance, is now equal to 6 percent of the national economy. Fifteen years ago, the last time the dollar was this weak on a broad basis, it was less than 1 percent of gross domestic product.

This year alone, the greenback has also fallen nearly 10 percent against the currency of the largest U.S. trading partner, Canada. China, the second-biggest, has allowed its currency to rise more quickly than in previous years.

None of this is lost on the Fed. Minutes from its June meeting showed it worried dollar weakness may lift inflation, though policy-makers may have accepted the current rate of decline.

"Central bankers and policy-makers don't want to see disorderly markets, be they Treasuries, equities or foreign exchange," said Kim Rupert, managing director for global fixed income analysis at Action Economics, LLC in San Francisco. "As long as conditions stay pretty orderly I think policy-makers will let it ride."

Historically, the dollar has been strong during extended periods of subdued inflation, while the greenback's most pronounced weakness during the early 1980s coincided with the highest levels of price growth recorded around the period of stagflation.

It helps that recent data suggests the Fed is slowly taming underlying price growth. Ironically, though, this is an argument for lower yields, and potentially a weaker dollar.

Not to worry, say some analysts, who see this as part of an economic cycle that may involve even more dollar losses as the Fed positions to cut rates to shore up growth.

"Things are going to get really nasty," said Andrew Brenner, market analyst at Man Financial in New York. "Then the Fed is going to ease, then the dollar gets hit, and then things start to get better again."


Additional reporting by Pedro Nicolaci da Costa and Kevin Plumberg.

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