Why the Dollar Is Tanking as Cairo Burns

When a world crisis erupts, such as the current fighting in Egypt, investors usually flee to safety. Historically, that has meant piling into the U.S. dollar. But a funny thing happened when protesters took to the streets of Cairo: The dollar tanked.

The dollar has fallen 5.5% since its recent peaked on Jan. 10, though it regained a little bit of ground Wednesday. What's causing the retreat?

Turns out, the answer is more likely found in Europe than in the Middle East.

Kathy Lien, author of The Little Book of Currency Trading, says investors are looking at inflation expectations in Europe, which are much higher than in the U.S., and they believe "central banks may raise interest rates this year."

"Inflation expectations and the countries that are most vulnerable to inflation pressures are the ones seeing their currencies rise the most," Lien says. "The U.S. dollar is being sold across the board because the Federal Reserve told us last week that inflation is still trending downwards."

German Bonds Get More Attractive

Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York, says it's not only interest rates that affect the exchange rate, but interest rate differentials.

As an example, Chandler notes that in early January, the two-year U.S. Treasury bond had a yield 20 basis points below the yield on a two-year German bond. Today, that differential has widened to 80 basis points, making the German bond more attractive because it uses the euro.

The European statistical agency reported Monday that prices in the eurozone had risen 2.4% in the last year, well above the European Central Bank's target of 2%. The bank hasn't indicated that it's about to raise interest rates, though the markets seem to have priced in an interest rate increase.

"A Dangerous Game"

Even worse than the eurozone is what's happening in Britain. U.K. inflation estimates are up to 3.5%, and the pound has risen sharply against the dollar, even though the country had 0.5% contraction in fourth-quarter GDP.

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"The U.K. is playing a dangerous game," Lien says. "Not only is inflation above the target, but it's above the comfort zone of 3%. It could get to 4% to 4.5%. They have this bizarre belief it's just going to go away."

Chandler says another factor boosting the euro is that European debt crisis fears appear to have eased. For months, investors have been concerned that countries like Greece, Spain and Portugal might be unable to pay their debts, and were considering a default. In response, the European Union and the International Monetary fund set up a temporary fund to help weaker countries borrow, and a permanent larger fund is now being considered.

"We've had a huge debt market rally in Europe in the last week as people became more convinced that European officials will come up with a larger comprehensive plan," Chandler says.

The New Carry Trade

The result is the so-called carry trade has been reinstituted. The term used to apply to many small investors in Japan who would borrow yen at less than 1% and buy Australian bonds paying 8%. Now, that trade has been replaced by speculators borrowing dollars for less than 1% and buying high-yielding emerging-market currencies like the Brazilian real, which currently yields 10.75%.

This time around for the dollar, what's happening in Europe economically is outweighing what's happening in the Middle East politically.