Good news as bad news and the dollar

“The U.S. dollar is going to fall quite a lot, or at least significantly,” he said. “The demand for dollars has been temporarily inflated by the crisis. Good news is actually bad news for the dollar. If things stabilize, then the safe-haven demand for dollars falls off.”

- Paul Krugman

Krugman makes an important point in a recent speech which explains the difficulty with some fundamental market relationships relationships in exchange rates. Under normal environments, a increase in relative growth in the US would be good for the dollar. Stronger demand will increase the demand for money and increase the supply of capital flowing into the US. 

Unfortunately, we have been in an upside down world where first there was a strong flight to quality into the dollar even though the crisis epicenter was the US. Now that the global economy is starting to stabilize we are seeing a fall-off of the dollar and funds move to riskier assets. The better the news on the US economy and so with it the rest of the world, the more we will see dollar declines. This is the risk aversion story.