Markets gain their excuse

Chaos in Moscow. Dollar rises, Deutschemark falls. The knee-jerk reaction to the events in Russia was predictable, with both gold and the dollar shooting upwards on the markets. The idea of a 'safe haven' in troubled times remains powerful, though to judge by the way in which both gold and the dollar fell back again the potion has only a very temporary effect.

But sometimes these knee- jerk reactions say something more about investment attitudes, and the rise of the dollar, particularly against the mark, is one such case. Rationally the case for buying dollars and selling marks because the Russian parliament building is in flames is thin, but it does exist. It is worth disentangling the rational from the emotional.

There are at least three reasons behind buying the dollar and selling the mark. One would be an acknowledgement that to some extent at least instability in Russia hurts Germany more than other industrial countries.

It hurts it in two ways, financial and economic. Germany is the largest creditor of Russia - which is why it opposed plans for debt forgiveness that were discussed (in a fairly desultory way) at the annual meetings of the International Monetary Fund and World Bank last week in Washington.

Russia's ability to repay debt may on a medium-term view be enhanced by the events of the past 48 hours, for the nation's finances could benefit from a period of strong presidential leadership. But in the short term gunfire in the streets frightens the bankers.

It also, again in the short term, damages the economy. While German industry does not depend in any measure on exports to the former Soviet Union and its energy imports are unlikely to be affected, the poorer the performance of the Russian economy the greater the ripple effect through Eastern Europe and, in turn, the smaller the opportunities for German industry.

The second reason is purely a domestic US one. President Bill Clinton has been making some recovery in the US approval ratings, helped by the encouraging way in which the health programme has been received. But problems in other countries always tend to push approval ratings higher - the foreign crisis enables the leader to carry more authority, if only by taking attention away from domestic ills.

Couple this with the fact that chaos in Russia emphasises the solidity of the US democractic system and there is a modest rational case for switching funds into the States.

But all these are marginal. Most interesting is the third reason for the strong dollar. The events in Moscow give the markets the excuse to do what they rather wanted to do anyway, which is to short the mark. This often happens.

Before markets make a significant shift of direction they look around for excuses to move, to test the water. They keep making little forays in the direction they intuitively want to go and then retreat if, so to speak, the water proves too cold for the plunge. The mark is in such a situation now.

Most professional currency-watchers believe that a year from now the mark will be lower against the dollar than it is today. The rationale is that German interest rates will inevitably fall, inflation will recede and the recession faces a second downward leg while US short-term interest rates will, with almost equal inevitability, rise somewhat.

Come the summer of next year, US and German interest rates may not yet have crossed over, but they will be close together with little current advantage in the mark vis-a-vis the dollar.

The trouble with this conventional wisdom is twofold. It says nothing about the timing of the shift. And, while there may be some way still to run, the dollar's potential upside may be smaller than the market expects.

For the dollar to move much upwards against the mark there needs to be a trigger, either political or economic. The most likely political trigger would be events similar to those we have just seen. The most likely economic trigger would be clearer evidence of the US recovery and/or of a double dip in Germany.

The wise would look at economics rather than politics, to judge by yesterday's experience on the markets. If that is right, the timing of any significant upward move of the dollar will most likely have to wait for a couple of good quarters of US growth.

Even then, the upturn may not be as strong as dollar bulls hope. This is partly because the Bundesbank will continue to use a reasonably strong mark as an anti-inflationary weapon and partly because the general perception that the mark is overvalued is flawed.

On a long view, purchasing power parity determines currency relationships. Calculations earlier this year by Citibank suggest a dollar around DM1.75. That would justify some further rise in the dollar, but not much.

Of course currencies can and do overshoot, but there is no need for that. The fact that PPP calculations are inexact could even be used to justify present rates, for they are certainly within the margin of error.

In the end there probably will be a surge in the dollar at some time during the next few months. There will certainly be attempts by the markets to have a crack at the DM. But we are in one of those periods where there is no obvious candidate for a currency realignment - no currency that is so hopelessly wrongly valued that a revaluation or devaluation is inevitable.

So expect more surges like yesterday's, particularly if the economic news points in the same direction as the political. But do not expect easy speculative profits from the exchanges over the next 12 months - or, at least, not as easy as the money made since September last year.