Currency markets woke-up to the cost of bail-out

Simple models of currency behavior tell the story about where the dollar should be headed - down. First, look at a simple monetary model of exchange rates. In this case, a rise in the growth rate for money relative to other countries will lead to a decline in the exchange rate. The market will have to clear at a lower level with the money supply shock. Second, we can take a portfolio balance model and look at a shock to the amount of debt that will have to be issued to bail-out Wall Street. Again, the shock will be dollar negative, because the price of dollars will have to fall in order to hold the risky assets in a portfolio.

The dollar has already closed over 2 percent lower from Friday relative to the euro. Less for some of the other major G10 countries but a clear dollar rout. Coupled with an already high current account deficit and no change in recession forecasts, we are looking at a perfects storm of bad news for the dollar.

The dollar rally was based on three forces. The reduced uncertainty associated with the guarantee on Fannie and Freddie rescued the portfolio outflow problem in the debt markets. Second, the idea that the US economy was stronger than expected and that the US may have turned the corner on the credit crisis through aggressive monetary policy was causing interest in the US as a safe haven. Third, the European economic numbers fell off a cliff starting in July. Uncertainty has now returned to the debt markets of what will be the supply necessary to make the bail-out work. The US economy is not showing any good numbers, and Europe bad news has been discounted.

It is unlikely for this dollar decline to reverse given the Congressional review may not reduce the size of the bail-out. It is not improbable for the dollar to retrace much of the its gains from the summer.