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Five Misconceptions About the Dollar
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By Mark Dow
Special to TheStreet.com

11/15/2007 10:28 AM EST
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The dollar is an extremely misunderstood creature. Just from listening to TV and reading in the press over the past week, I have run into comments about the dollar, spoken with great conviction and repeated frequently, that don't pass the smell test.

Here's a short list:

  • Flight to quality. How many times have we heard that phrase when the dollar rises as equities sell off, as we saw late last week?

However, you have to stop and ask yourself, if the decline of the dollar and the deterioration of the economic fundamentals in the U.S. are the very reasons for the generalized risk-aversion, as has been the case of late, why would "flight" into dollars be "quality"? Doesn't make sense, does it, especially when "everyone" agrees that the dollar's fundamental weakness is because of the U.S.' "twin" deficits?

Of course it doesn't. The reason the dollar tends to rise when markets experience high levels of risk-aversion is very simple: Investment funds all over the world are predominately denominated in dollars, especially hedge funds. When portfolio managers start to lose money beyond a certain level, they reduce risk. This means getting flat, going home, selling whatever it was that you were in, buying dollars and getting closer to cash or to your benchmark.

Why haven't people caught on to this? The reason people still say "flight to quality" is that we in the market are slow to recognize paradigm shifts. Our analysis tends to be hindered by excessive reliance on the rearview mirror -- for example in taking some five years to recognize the positive -- not negative -- correlation between the price of oil and the S&P 500, because in previous oil crises the relationship was indeed negative.

  • The Fed is deliberately debasing the currency. Lowering rates, it is argued, means pumping money into the system, and the faster growth of the dollar money supply relative to other money supplies induces depreciation of the dollar. I understand the risks of saying anything that is not unambiguously negative about a government entity, but this Fed-bashing sound bite has two problems, one factual and one conceptual.

The fact is that base money -- the element of money supply that central banks control -- has been growing faster in Europe than in the U.S. for the past five years. So you can hardly accuse the Fed of deliberately debasing the dollar with the printing press and/or helicopter drops.