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The dollar looks as it might have caught more than just a common cold.
Over the past day or so, the U.S. currency has had a classic opportunity to rally.
Global risk appetite has subsided, commodity currencies have fallen and investors were only too keen to take profits.
But the dollar’s response to all this has been feeble.
Instead of bouncing out of bed, the currency looks only too ready to fall back again, dashing any market hopes of an early recovery.
The dollar has long been ailing because of the steady realization in recent months that the U.S. Federal Reserve will trail behind most other major central banks when it comes to tightening monetary policy.
With currency markets once again being driven largely by yield, this is putting the dollar near the bottom of the G10 carry-trade league.
Despite the occasional hawkish comment from Fed officials, it has become clear over the past week or two that the U.S. central bank isn’t about to start tightening policy. In fact, there is talk that the bank’s ultra-easy policy, known as QE2, could now be extended beyond June.
As this has coincided with last week’s decision by the European Central Bank to raise its interest rates for the first time since 2008, yields have moved even more against the dollar.
However, the U.S. is also now suffering from two other serious symptoms: fears over a debt default and a return of reserve diversification.
The first has risen after Congress struggled at the end of last week to come up with a compromise as the government seeks to raise its $4.13 trillion debt limit even further.
Bill Gross, manager of Pacific Investment Management, the world’s largest bond investor, has already warned that the risk of a U.S. default is growing and that the price of U.S. Treasurys will fall as investors demand higher yields to account for that risk.
The other reason for doubting the dollar’s ability to stage an early recovery is the growth in diversification flows. The U.S. currency’s recent weakness forced many Asian central banks to intervene to stop their currencies from rising too far.
Now, these same banks are keen to diversify the dollar-denominated reserves into currencies such as the euro and other high-yielders at the expense of the dollar.
With the dollar suffering from symptoms as bad as these, its recent poor performance was hardly surprising.
New fears about the strength of radiation leaks from the damaged Fukushima nuclear plant in Japan, Goldman Sachs’ recommendation that the time has come to start selling commodities and the IMF’s warning that high oil prices will damage global growth should have provided a tonic for the dollar.
Risk appetite receded, demand for high-yielders fell and the dollar should have been back in favor.
However, its gains were small and its rally failed to show any momentum with the dollar index on the verge of returning to its 16-month low just under 75.
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