Jeremy Warner: Dollar weakness is a sign that things are on the mend

Thursday 04 June 2009 00:00 BST

Outlook Remember the glory days of two dollars to the pound, when depending on how much they were spending, it almost made sense for Brits to hop on a plane and go shopping in New York? Well, we are not back there yet, but the dollar has weakened markedly in recent weeks and the pound is one of its chief beneficiaries.

There was a slight hiccup in the trend yesterday, brought about by reports that unnamed "Asian monetary officials" had promised to keep buying US Treasuries even if the US loses its triple A credit rating. Yet the trend is unmistakable, and if even the pound has been gaining in strength – the UK is generally thought even more bust than the US – then something must be going on.

For some, it's the beginning of the end of dollar hegemony – the point at which China and other surplus nations decide to stop funding the US trade and budget deficits and instead apply their surplus savings to something else. Rising Treasury yields would seem to confirm the idea that international investors are losing faith in the US's ability to manage its monstrously growing fiscal deficit.

Yet if this were the case, you would expect the pound to be even more brutally assaulted than the dollar, for Britain's fiscal challenge is proportionately just as bad, if not worse. In fact the reverse is true. The pound has been strengthening against both the dollar and the euro.

So what's going on? Forget Britain's political crisis. This is of no real relevance to financial markets right now. The possibility of a Tory government, more committed to the principles of sound money and fiscal consolidation, might I guess cause some renewed international confidence in the pound and UK gilts, but by the same token it might also have the effect of snuffing out the green shoots now observed in the service sector and the housing market. The two things would cancel each other out. It's a sad reflection on his premiership, but Gordon Brown's fate is a matter of indifference to financial markets. The assumption is that whoever's in the hotseat will in the short term at least be forced to follow broadly the same economic policies.

The explanation for these currency and bond price movements is neither fiscal meltdown in the US nor Labour's death throes in the UK. Rather, and perhaps counter-intuitively, it lies in the fact that the policy response to the economic crisis is working as intended. Confidence is returning to financial markets, if not yet the real economy, where unemployment is likely to continue rising well into next year.

During the depths of the financial crisis, the dollar reverted to its traditional safe haven status. US nationals repatriated their money. There was a flight to the perceived safety of dollar assets among international investors, too. As fears of a worldwide depression grew, US Treasuries soared and yields sank to record lows.

These fears have now receded. The fact that the dollar is now weakening and that Treasury yields are back to more normalised levels is evidence that confidence is seeping back, not that international investors are abandoning the dollar and US Treasuries wholesale in protest at the size of the deficit.

Instead, investors are rediscovering their appetite for risk and are beginning to dip their toes back into other things, including corporate debt, equities and even the little old British pound. This is just what the doctor ordered. Three months ago, the primary concern was deflation. Now people are worrying, if only a little, about inflation again.

In Britain, the purpose of the Bank of England's programme of "quantitative easing" was to depress gilt yields to a point where investors might be tempted back into chasing yield through purchases of higher risk assets, thereby restarting the process of credit creation. In fact, gilt yields have been rising relentlessly almost from the moment the QE purchases began.

But this is not a sign that the policy isn't working. To the contrary. What it means is that investors are losing their appetite for gilts and rediscovering their hunger for other, riskier assets. This may not be helpful to the Government's short-term funding needs, but if it means that financial conditions are returning to normal, then it is basically good news for everyone, including whoever next inhabits Number 10, for the road back to fiscal health ultimately depends on the bigger tax take that comes with an improving economy.

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