Dollar Bears to Rule 2010 (and beyond?)

During a speech last Wednesday, Federal Reserve Bank of St. Louis President James Bullard made a comment that the Federal Reserve may not raise interest rates until sometime in 2012. While not many are expecting an increase in lending rates in the short-term, maintaining the current rate for another two years or more, seems rather extreme and created a bit of a stir as the markets considered the impact this could have on the dollar.

Bullard cited past experience as the basis for his reasoning, stating that “if you look at the last two recessions, in each case the FOMC waited 2 ½ to 3 years” after the recession ended, before raising interest rates. Following this line of reasoning, the suggestion is that it will be mid-2011 before we can expect a rate increase, so does this mean the dollar will remain weak until then?

Not exactly. According to Callum Henderson, it will actually take another full year beyond that before the dollar will realize significant gains.

“History tells us the dollar shouldn’t start rising on a sustained basis until 12 months after the Fed starts to lift rates” says Henderson who serves as a currency analyst with the British-based investment bank Standard Chartered. Henderson also notes that the market is suffering from an “oversupply of dollars” because of global stimulus programs, and the dollar “will remain weak until the Fed’s rates rise above the competitors”.

Therefore, if you accept James Bullard’s suggestion that an increase in lending rates is at least two years away – and if you also believe currency expert Callum Henderson is on the mark with his assessment – it could well be that the dollar will not only struggle through 2010, but 2011, 2012, and 2013 are all shaping up to be challenging as well.

Of course, the dollar’s value is based on more than just interest rates as noted by Gernot Griebling of the Landesbank Baden-Wuerttemberg headquartered in Stuttgart. Griebling believes that “financial markets and equity markets have been too optimistic concerning economic growth next year”, and he is of the belief that the need for widespread risk aversion will have investors turning back to the dollar. Griebling even goes so far as predicting that the dollar will strengthen to $1.37 per euro by the end of September compared to the current rate of about $1.49 to the euro.

Griebling does give us something to think about. Over the past six months, commodities and financials have helped boost market returns, but in the back of my head I still hear a little voice saying “too much, too fast”. I can also hear Roubini warning us all about a recession “double dip” he maintains will be brought on by a sudden revaluation in the equity markets once investors realize that the fundamentals do not support current price levels. Should things play out in this manner, there will certainly be those that turn to the dollar for short-term safekeeping.

The potential for this “flight to safety” scenario notwithstanding, I still don’t see any reason to believe that the dollar will make significant gains over the other major currencies within the next 12 months. It would appear that many Central Banks are with me on this one as Russia, China, India, and now Sri Lanka, have all sold billions of dollars in order to buy gold for their foreign currency reserves. Consider also that the Central Banks have made these purchases even as gold seems to hit a new record high on a daily basis, suggesting that the Banks clearly believe holding gold right now has a greater upside potential than holding dollars.

Even if the pace of gold buying by the Banks subsides in 2010, I don’t believe they will reverse direction and start buying dollars any time soon. No, that ship has sailed and it will take a dramatic change in the outlook for the greenback before Central Banks abandon their diversification programs.

Line forms here for the dollar bears.

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