Quantitative Easing: The Start of a New Bear Market for the Dollar?

The only function of economic forecasting is to make astrology look respectable.

- John Kenneth Galbraith

If economic forecasters resemble astrologers, currency forecasters must read tea leaves. Almost everyone was a dollar bear in the middle of last year when the euro touched 1.60. Then the global economy cratered because our financial system and economy imploded, and that resulted in... a dollar bull market. For the next few months forecasters predicted a stronger dollar and dire consequences for the euro and the European Union. Now, the Fed announces the start of quantitative easing (QE), which everyone knew would happen sooner or later and should have been baked into the forecasts. Apparently not - the dollar has swooned and there are now predictions of a new dollar bear market, especially vs. the euro.

The euro has been sold aggressively in recent months and was probably due for an oversold rally. It has become increasingly clear that the European Union and ECB will do what they can to preserve the union and support the weaker countries, at least for now. Risk appetite has partially recovered and as a result, U.S. Treasuries have lost some of their safe haven appeal. European rates are higher than in the U.S. and the ECB has not yet embarked on quantitative easing. A combination of those factors probably account for most of the euro's rally this week. But is this the start of a new longer-term dollar bear market? Not if it is based on just those largely short-term circumstances.

There is another reason for the dollar to remain under pressure and it could prove significant. If Treasuries rally further as a result of the Fed's actions, they could be viewed as too richly priced (low-yielding) by foreign investors, which would reduce demand for them even further. January's TIC data showed a significant drop in overseas demand. Even though some demand probably returned in February as equity markets slid, the trend is not reassuring for dollar bulls.

On the other hand, it is likely that more central banks will go down the path of QE. The ECB will probably be one of them, following the precedent set by Britain, Switzerland and the U.S. With large-scale fiscal stimulus not favored by most countries and deflation a growing reality for most G20 countries, QE is relatively risk-free in the short run. It remains to be seen how effective it will be and what are the longer-term consequences. What is fairly certain is that once other countries embark on it, downward pressure on the dollar will abate. Bear in mind that in the current environment of weaker growth and a deflationary environment, most countries would welcome, if not actively encourage, currency weakness. It can help in many ways, most of them short-term, so expect protests if the dollar gets too weak in the coming days.

Lessons from Japan's attempts at QE during their "lost decade" and other examples from history are fairly conclusive. In the short-term, QE exerts downward pressure on a currency - it only recovers when the economy shows signs of life and if the central bank regains control of money supply. In this cycle, with the likelihood of multiple countries embarking on QE at around the same time, long-term currency performance will depend on which economies respond the quickest and most significantly and which central banks retain (or regain) credibility.

In my opinion, this dollar swoon is a knee jerk reaction and will probably correct over the coming weeks and months, once the ECB and other central banks follow suit. Longer-term, I still believe the U.S. economy and the dollar face severe headwinds and the dollar will weaken - QE does little to change that. I had expected the dollar to rally moderately over the next quarter or two, before declining into 2010. The Fed's actions may limit the dollar's near-term bounce, but not its longer-term decline. That will be caused by high levels of unemployment and mounting budget and trade deficits, which will constrain GDP growth for the next few years.

For those with foreign currency payables who failed to take advantage of recent dollar strength, there may be other opportunities, but possibly at less attractive levels. However, trying to fine-tune entry points can sometimes result in missing the big move. If I am right, a secular dollar bear market will begin later this year and possibly last for several quarters, maybe years.