Out in the cold?

The turmoil in the Middle East and the resulting spike in oil prices is spooking investors of all stripes, and currency traders are seeking out safe havens. That is usually good news for the dollar.

Just not this time.

Even as the Swiss franc hits record levels and the yen is propelled upward, the dollar is sagging. It even hit a three-week low against the euro on Wednesday.

Has the dollar lost its safe-haven status? Not exactly, but the state of the U.S. economy is keeping traders wary. With economic indicators like new home sales, jobless claims and durable goods orders, all released today, pointing to a slow, uneven recovery with little job growth, traders don’t expect the Fed to raise interest rates any time soon. Since interest rates tend to propel currencies higher, investors are focusing on countries with stable outlooks and tighter-money policies, or at least some indication that they might raise rates.

“Unemployment is still very high, and if the Fed were given a choice between inflation or unemployment to worry about the most right now, chances are they’d continue QE2” and defer any interest rate hikes, says Diane Swonk, chief economist at Mesirow Financial. “That’s in contradiction to what other central banks are doing right now,” with inflation hawks raising their voices in the eurozone and even the People’s Bank of China taking steps to curb inflation.

Sacha Tihanyi, a currency strategist at Scotia Capital, concurs. "The dollar’s inability to rally may this time be much less a reflection of the market’s view on the path of U.S. monetary policy, but more on the view of the path of policy in other major currency countries,” she says.

Then there is fiscal policy. Paresh Upadhyaya, head of Americas G10 currency strategy in New York for Bank of America Merrill Lynch, says that in addition to concerns over low U.S. interest rates, investors may be spurning the dollar because of the large government budget deficit - on track to increase next year, unlike other G4 countries - and the prospect of a government shutdown on March 4.

What could change the dollar’s path? A sustained increase in the price of oil would create immediate and dramatic inflationary pressure, with unpredictable effects for the dollar and many other currencies. Any major change in monetary policy by the Chinese would also affect the dollar: if the Chinese started clamping down harder on inflation, and buying fewer dollars – a process that has already begun – that could create further downward pressure on the U.S. currency. On the flip side, if conditions deteriorate in the eurozone, with some peripheral countries weakening further, the dollar might look like a relatively stable alternative to the euro.

In short, the outlook for the dollar is fluid. And the current weakness relative to the other safe-haven currencies may not be such a bad thing, Swonk says.

“It’s arguable that the dollar has been a grossly overvalued currency for a long time because it is a reserve currency, and people use it for more than just exchange purposes,” she says. “We’d welcome some dollar depreciation because it helps exports. I’m not sure it’s an unwanted thing.”

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