Barry Eichengreen: Now is a Good Time to Sell the Dollar

Barry Eichengreen says if you have dollars and believe the chance of a recession is increasing, now would be a good time to sell them:

Now is a good time to sell the dollar, by Barry Eichengreen, Commentary, Financial Times: Does the subprime crisis bode the long-anticipated unwinding of global imbalances? ... A recession ... has long been seen as one way in which global imbalances could be “corrected”. ...

But the recent behaviour of the dollar is difficult to reconcile with the impending unwinding of global imbalances. If domestic spending falls, US producers will have to rely on foreign customers. The dollar will have to decline to price American goods into foreign markets. If the dollar has to fall in the future, traders should be selling it now.

In fact, however, the dollar has been one of the principal beneficiaries of the subprime crisis. It has risen against the euro. It has risen against sterling. It has risen against a variety of emerging market currencies.

It could be that the foreign exchange market is signalling that the probability of recession is low. ... But it is not plausible that the probability of a US recession has declined in recent weeks... This is what the strength of the greenback would imply were this explanation correct.

The alternative is that the dollar has benefited from the flight to quality. As investors have rediscovered risk, they have rushed into US Treasury bonds. ...

This explanation is also a bit hard to stomach... [I]t is hard to believe that there are fewer financial landmines below the surface in the US than Europe. The exchange rate of the dollar depends on ... the entire range of dollar and foreign currency-denominated securities. That investors are shifting towards claims on the entire range of American creditors to avoid risk hardly seems plausible.

Private foreign investors, some of whom may have realised that a variety of American debt securities were riskier than advertised, have long since stopped financing the US current account deficit. But foreign central banks ... have continued accumulating claims on the US. When seeking higher yields, they have diversified out of Treasuries into other US debt securities.

But, eventually, the subprime crisis will drive home the point that they pay for that additional yield by assuming additional risk – even more risk than previously supposed. ... Foreign money to finance the US current account deficit will become less abundant. The period of credit stringency will linger. US spending will suffer. And the dollar will fall.

In the short run, exchange rates have a life of their own. The ... short-run movements tell us little... But over longer horizons ... we can have more confidence about how these variables are related. If a slowdown in US spending is coming, then the dollar will have to fall to price US goods into foreign markets, precisely as posited above.

For those who believe that the subprime crisis heightens the likelihood of a US recession, the dollar’s rise offers an obvious selling opportunity. Recent market moves suggest that investors may have begun cottoning on to this fact.