Desperately Seeking Dollars: Greenback Catches a Bid

This post first appeared on Minyanville.

The phenomenon has many market observers scratching their heads: The US dollar is marching steadily upwards, despite the fact that the American banking system is on the ropes, the Federal Reserve is printing money at a record pace, and Washington wants to increase our already multi-trillion dollar deficit.

And while the answer to this conundrum is indeed complicated, its roots lie in how economic participants react to economic crisis and, ultimately, to deflation.

According to Bloomberg, in banking panics past, lenders tended to focus on doing business at home, rather than abroad. This makes logical sense: Bankers want to begin by helping those in their own backyards. The ongoing spat between Western and Eastern Europe, with the latter begging the former for help, is evidence that saving one’s own skin tends to take precedent when times get tough.

As a result, countries heavily reliant on foreign lending tend to fare poorly when such currency “protectionism” takes hold. Despite profound troubles at Citigroup (C), AIG (AIG) and Bank of America (BAC) -- to name but a few US financial institutions swimming in shark-infested waters -- many believe our banks, and indeed our economy, will fare better than those around the world.

Furthermore, as an economy spins out of control, politicians respond by firing up nationalistic rhetoric, urging a country’s citizens to band together. The widely-discussed “Buy American” provision in President Obama’s economic stimulus plan is but one example of lawmakers asking the electorate to “turn inward” in the face of danger.

Returning to the dollar, in addition to investors betting on the American economy to outperform its international counterparties, ongoing deleveraging favors the American currency. Dollar-denominated debt must be repaid with dollars, and as debtors scrounge up greenbacks to pay back their creditors, dollars become more scarce, driving their value upwards.

Deflation, which goes hand-in-hand with deleveraging, encourages consumers to hold on to cash, since as prices fall their dollars stretch further tomorrow, than they did today. Housing is a perfect example -- why buy a home today that will be worth less tomorrow?

The dollar is now approaching a near-term high not seen since the last time equity markets plunged to new lows (last November). This echoes Toddo's persistent theme of "asset class inflation vs. dollar devaluation." It's no doubt policymakers and the Plunge Protection Team are acutely aware of this relationship -- it's now a question of when, and how, they'll act.

Stay tuned, as Mr. Practical is apt to say: Risk is high.