Are investors fleeing the dollar?

Now the interesting time for the dollar begins. Despite record monetary and fiscal stimulus, the dollar through mid-year held its own against the world's other major currencies, aided by a general flight to safety and risk aversion by institutional investors during the financial crisis and recession.

But now it appears that both the U.S. and global recessions are bottoming, and the ensuing increase in risk appetite and desire to deploy capital in higher-return assets is generating a long-predicted flight out of the dollar.

The dollar weakened almost two cents versus the euro, British pound, and Swiss franc Friday, to $1.4137, $1.6138, and $1.0957, respectively, on a global search for higher returns. The dollar also fell 1.4 yen versus Japan's yen to 95.45.

Investors seeking higher-return assets?

If, in fact, the U.S. and global recessions are ending, that could mark the start of a "downward correction period for the dollar," so says Currency Trader Andrew Resnick.

"It remains to be seen how much money flows back to Asia and other destination, such as Latin America," Resnick told DailyFinance Friday. "The dollar should hold its own against the euro because Europe is later in the economic cycle than the U.S. And provided the U.S. economy shows further signs of recovery, that would tend to put a lid on the rally in the British pound and euro." Resnick added that he is presently flat, or has no open currency trading positions, his normal status for a Friday.

Further, Resnick cited one positive and one negative, in the event the dollar weakens another 10-15 percent versus the world's other major currencies. The benefit: it will lower the cost of U.S. exports to purchasers abroad, making those U.S. goods/services more attractive – something that will likely further decrease the U.S. trade deficit.

The negative? U.S. interest rates will continue to rise – U.S. Treasury interest rates again jumped higher this week – as the U.S. government is forced to increase short-term rates to fund its record budget deficit and national debt, and attract capital that has other, and in many cases higher-return, options available, Resnick said. The yield on the 10-year Treasury note has risen about 50 basis points in May to 3.56 percent after rising 46 basis points in April.

Further, because many home mortgage rates are driven by changes in the 10-year Treasury rate, mortgage rates will likely rise with any increase in the former, Resnick added, complicating the recovery in the U.S. housing sector.

"If that occurs, that is exactly what the Fed and Obama administration does not want to see happen. We want mortgage rates to remain relatively low to stimulate home sales, but the budget deficit is paramount. U.S. Treasury has to increase the rate it offers to attract adequate capital to fund the deficit," Resnick said.

Economic Analysis: Until now, the U.S. had gotten away cheap regarding its ability to deploy both monetary and fiscal stimulus, without a plunge in the dollar or a rise in interest rates, due to risk aversion and lack of demand. But now it looks like the recovery beckons and there will be other, potentially-promising investments for institutional investors. In addition to a flight out of the dollar, that creates an environment where there's competition for capital – i.e. a climate ripe for rising interest rates.

The above underscores the need for U.S. policy makers to cut the budget deficit, after the economic recovery is place, in order to reduce both capital demand and the upward pressure on interest rates.
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