Why the Dollar Is Stuck at Three-Month Lows

There's a crisis in the Middle East, oil prices are skyrocketing and U.S. manufacturing is rebounding smartly. So why is the dollar stuck at three-month lows when it should be surging?

The short answer is: It's all about interest rate perceptions. Countries as far apart as Sweden, Britain and Brazil are considering rate increases as commodity costs soar. When interest rates go up, currencies become more attractive because they pay investors more for holding them. So those currencies tend to rise.

Hit Hard by Oil Prices

Investors in Europe are looking on in horror as the price of Brent crude surges past $114 a barrel, raising the prospect of inflation there. The European Central Bank (ECB), whose sole mandate is to keep a lid on prices, is meeting Thursday and is widely expected to take steps toward modestly raising interest rates. As a result , the euro continues to hover near its highs of $1.38.

The U.S. has been hit just as hard by higher oil prices, but the perception is different here. "While the Federal Reserve believes higher oil prices may raise headline inflation, it is also a dampener on the economy. So, they would be less likely to respond to higher oil prices with a policy move," says Robert Sinche, global head of currency strategy at RBS Global Banking and Markets. U.S. interest rates will apparently remain low as other nations move higher, making their currencies more attractive.

Fed Chairman Ben Bernanke didn't help matters much on Tuesday. He indicated the Fed's program of buying $600 billion of long-term Treasurys was regarded as a success and that the program will continue until its scheduled end in June. Bernanke told a Senate hearing the bond buying, known as quantitative easing, had the same effect as 75 basis points of interest rate easing. The bond-buying program is only half over, so the dollar will be under downward pressure for another three months.

And that's despite a report from the Institute of Supply Management, that its U.S. manufacturing index moved to 61.4 in February from 60.8 in January, its best performance since 2004.

Putting Fear Into the Markets

"Normally, when you get these kind of explosive numbers, you expect the market to say these could have an impact on Fed policy over the next three or four months," Sinche says. "But because they are so locked into finishing quantitative easing -- and there is certainly no indication the chairman is wavering on that view -- that short-circuits what might be a normal transmission mechanism between very strong data, Fed policy reaction and the dollar."

Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York, believes that hawkishness by the Europeans has been just as important in affecting the dollar's value. In January, ECB President Jean-Claude Trichet said he was concerned about price rises -- and reminded the markets he had boosted European interest rates in July 2008, even when the continent's economy was contracting.

"He basically gave the markets a fear of God," Chandler says, and the markets responded by rushing to cover their bets against the euro moving lower, which pushed the single currency much higher against the dollar.

"Like a Modest Tightening"

The ECB is scheduled to have its policy meeting on Thursday, and tougher language on inflation could send the euro higher. The ECB is also expected to take steps to normalize its liquidity program, which was adopted to help banks in periphery countries such as Greece, Portugal and Ireland. It offered member banks unlimited amounts of euro loans at 1% interest.

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The ECB has already ended 12-month and six-month liquidity programs and is now expected to end its three-month liquidity provisions, which Irish banks drew upon for 95 billion euros in January. That move "reduces the availability of funds and is like a modest tightening of policy," Chandler says.

The Bank of England is also meeting on March 10 -- amid word it may have switched its orientation and, after inflation has run above target for more than a year, is now leaning toward a rate hike.

Then there's the question of a safe haven effect. Usually in a world crisis such as the one unfolding in the Middle East, investors pile into greenbacks. But this time, the dollar has gone down and the Japanese yen and Swiss franc have gone up.

According to Sinche, this is because "the markets are just not enamored of the dollar as a risk-aversion safe haven and instead look toward countries that obviously run big current-account surpluses, such as Japan and Switzerland." In contrast, the U.S. ran a $1.3 trillion budget deficit in 2010.

Recirculating Petrodollars

Chandler argues that the U.S. is still a safe haven, but investors buy U.S. Treasurys as protection for their capital. With foreigners pouring money into Treasurys, that tends to force down U.S. interest rates, which reduces the attractiveness of the dollar.

Lastly, there's all that money flowing to oil-exporting countries -- which are now reaping upwards of $110 a barrel. Most of these countries have a reserve allocation that puts a percentage of their reserves into currencies other than the dollar. So, when Saudi Arabia receives $1 million from an oil sale, its central bank will sell $350,000 and buy euros or Swiss francs. That selling pressure, repeated around the world in petrodollar countries, also forces the dollar down.

All told, before the dollar could reverse the direction it's heading in now, an awful lot would have to change.