The New Global Balance - Part II: 2010: Higher Rates Rather than Weaker Dollar

Abstract

Since end-March, 10y US yields have increased 76bp, more than in other G7 markets (Figure 1), and a dollar index relative to major currencies indeed weakened 7.5%, (13.8% relative to developing countries, Figure 2). In this note, we argue that the narrowing of the US current account (CA) deficit may not be as benign as most believe. In our view, the CA adjustment partly reflects temporary considerations, and that global fiscal policy is likely not dollar-neutral even if global imbalances are reduced. Moreover, we document how quantitative easing (QE) has acted as a temporary choice of “rates over currencies”. Where does this leave us for 2010? We expect both monetary and fiscal policy to join forces when QE stops in early 2010 and push long-term rates higher. The end of QE in 2010 and the start of the tightening cycle in the US - both supportive forces for the dollar - should compensate dollar-negative fiscal considerations. In contrast with the growing dollar skepticism, we argue that the fast rebound of the US econmy should deliver higher rates in lieu of a weaker dollar.

Keywords: global imbalances, financial crises, exchange rates, US dollar

JEL Classification: E44, F02, G15