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How a Currency War Could Move the Dollar

Tuesday, 15 Jan 2013 | 2:45 PM ET
Jonathan Kitchen | Digital Kitchen | Getty Images

Don't look now, but while the euro has been rocketing higher, the dollar has been in a funk.

"The improved equity rally, still ever-dovish Fed, flattened U.S. curves, increasing liquidity, improving economic data" and rebalancing of central bank reserves in emerging market countries are all contributing to the dollar's doldrums, according to Richard Cochinos, a currency strategist at Bank of America Merrill Lynch.

If a currency war were to ignite, with various central banks competing to keep their interest rates low, that could change things, Cochinos said - but not for long.

While "an increase in rhetoric" from central banks "would be one sign of a turning USD, a byproduct of such an increase would be certain credibility issues that eventually become self-limiting," Cochinos wrote in a note to investors. In other words, countries at risk for higher inflation can talk all they want about keeping their currencies in check, but the inflationary risk that that would create would ultimately lead investors to question their credibility and limit the impact of their warmongering.

That credibility problem also means the dollar would only get a temporary lift from a pickup in currency-war talk, Cochinos said.

So what could boost the dollar in a sustainable way? Cochinos points to trade flows.

When China announced a larger-than-expected pickup in exports last week, and the U.S. reported higher imports, one currency that really got a lift was the euro. That means the reverse is also true, Cochinos said.

Trade, he said, "happens to have the largest impact on the USD currently. Therefore, a turn in trade surprises lower would send a strong signal that the USD weakness should begin to turn."

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