The US dollar and looming interest rate risk

Just two months ago, economists were predicting a protracted fall in the strength of the US dollar. But since then, the the fundamental and technical evidence points to a rebounding U.S. dollar, at least in the short term. This is significant because continued demand for the relative safety of US Treasuries could mean interest rates should remain on the low side for the foreseeable future. Maybe six months.

No alternatives - flight to safety

If the US economy was isolated from the rest of the world, US government (record deficit-spending) policy responses to the financial crisis should send the dollar into a free-fall. But economic problems are global and threaten the sustainability of a global recovery. That makes investors nervous, and when they’re nervous, they prefer to own US dollars. Global investors responded to the uncertainty by plowing money into the U.S. Treasury market. Currency values are determined as compared to the value of other currencies. With that in mind, the dollar is positioned to strengthen. However, at the risk of stating the obvious, things could change rather quickly once the global economy improves.

A January 2010 Bloomberg poll indicates of how quickly perception can shift. According to the poll, investors have turned bullish on the U.S., a stark contrast from the views just a quarter ago. It turns out the rest of the world is in poor economic shape. Comparatively speaking, the U.S. and the dollar appear stronger for the time being.

Interest Rates

Granted, there is no clear correlation between US dollar and nominal interest rates. But as long as there is demand, Treasury rates, which affect mortgage and other borrowing rates, probably won't need to rise as quickly in order to attract investors. That said, record deficits harbor the risk of inflationary pressures. Higher rates inevitably follow.

If you held a gun to my head and forced me to make a prediction, I'd say Treasury rates should stay steady for about six months before beginning a prolonged rise. This gives financial institutions a small window of opportunity to get their balance sheets in order. Interest rate risk looms as the next major hazard to their bottom line, as well as to the US banking system.

Tom Dluzen