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The dollar has had a torrid time since 2002: on a trade-weighted basis, it
has fallen 40 per cent. But now that the Federal Reserve has joined Washington in attempting to talk up the US currency, does its recent steadiness against the euro indicate a turn in its fortunes?

The bearish camp will take some convincing. The US current account deficit is a whopping 5 per cent of output. A weak economy is weighing heavily on the dollar’s reputation as a safe haven. Commodities are off a bit, but there are many out there who believe prices can go higher. Research by Barclays Capital has found that over the past year, a 10 per cent upwards move in the oil price has led to a corresponding 1 per cent move in the euro versus the dollar. That is because the European Central Bank has been more aggressive in lifting interest rates in response to rising prices.

In the short term, more hawkish rhetoric by the Fed and evidence of slowing European growth has narrowed the interest rate differential between Europe and the US by 40 basis points since June. But the narrowing of the yield gap may be short lived if the recent fall in the oil price reverses and US economic data continue to be more disappointing than news flow from the eurozone.

Further out, there is more cause for dollar optimism. Although demand for euros has increased, the International Monetary Fund’s latest figures show the dollar’s share of global foreign exchange reserves is high, at about 63 per cent, down only 2 percentage points from 1997. There has not – yet – been a seismic shift in allocation away from the dollar. Foreign buying of US Treasuries remains strong. Currency traders must ask themselves whether they really back Europe over the US to adjust more urgently to the post-credit crunch world.

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