Why fear is good for the dollar

Let's pretend we're back in the cheerful days of spring 2007. Imagine if you'd turned to the horoscope pages and read the following:

"In the next 18 months, a British bank will be nationalised, while the country's biggest mortgage lender will be taken over without a squeak from the Competition Commission. In America, the world's biggest insurance company and the most important mortgage institutions in the world will all be nationalised, and every one of the big five investment banks will have gone bust, been taken over, or abandoned the business model altogether.

"Oh yeah, and house prices will be falling at double-digit rates. And both the UK and US will be in recession by Christmas, if not already."

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It wouldn't have seemed possible that this could happen inside 18 months. Yet most of it happened in the past fortnight.

Events that were once unthinkable are becoming realities. And maybe that's why markets are starting to consider the last great financial taboo the idea that the US might one day go bust

Could the US lose its AAA credit rating?

This is now a serious question. With the government attempting to take on the bad debts of the entire financial sector (though getting the $700bn Troubled Asset Relief Programme (TARP) through the senate isn't proving easy), traders sold down the dollar sharply yesterday.

The US currency fell heavily against the euro. It even fell against sterling, which is currently one of the most hated currencies in the market. Meanwhile gold and oil rocketed. So could this be a major turning point?

The FT's Alphaville blog contained some interesting comments on an S&P credit report from April. The credit rating agency had argued that the bail-out of Bear Stearns was not important enough to threaten the US's credit rating. But it did suggest that a bail-out of Fannie and Freddie might be.

Well, as the FT puts it, the US has now bailed out Fannie and Freddie, and then AIG and now it's aiming for the rest of the financial system on top of that. "US GDP is around $13 trillion. The current bailout packages, taken together, are already, conservatively, weighing in at 10% of GDP. By S&P's own criteria, this is a huge 'contingent liability' and according to their April report, should almost certainly 'hurt the US's credit standing'."

So "perhaps the question is better posed: why hasn't [S&P downgraded the US] already?"

Well, for one thing, the $700bn bail-out plan hasn't been approved yet. Senator Richard Shelby, on the Senate Committee on Banking, Housing and Urban Affairs, said that the plan was "neither workable nor comprehensive." He wants a "comprehensive, public examination of the problem and alternative solutions we owe the American taxpayer no less."

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Fear is propping up the dollar

But for another, where else are investors going to run to? As fear has rapidly regained the upper hand in the markets, amid concerns about whether the TARP will go through, and more importantly, whether it will work even if it does get passed, the dollar's slide has been arrested.

The reality is that regardless of how credit-worthy the US actually is, it is still seen as one of the ultimate safe havens in troubled times. That may change, but for as long as investors are still in 'flight from risk' mode, the US has a powerful force propping up its currency sheer terror.

The alternatives simply can't generate the same levels of confidence in investors. The euro is probably the most obvious candidate for reserve currency after the dollar, but Europe has its own problems. The European Central Bank (ECB) certainly acts tough and probably has the most intact inflation-fighting credentials of any central bank. Yet with the likes of Spain, Ireland and Italy in trouble, the threat of a major structural collapse is hanging over the euro.

I'm not saying it will happen. And if the euro survives this global slump relatively intact, then it'll look like a serious contender. But there's some distance to go before that happens.

As for other currencies, most Asian players still want their currencies to remain weak against the dollar; the UK is arguably in even more trouble than the US; and Australia is also heading for a slowdown.

In short, as long as fear reigns in the markets, the dollar may be weakened, but it's likely to cling to reserve currency status. It won't be until other countries genuinely feel able to thrive in a world where the US isn't driving the global economy, that serious alternatives to the dollar will arise. So ironically enough, it might not be the recession and depression that kills the dollar, but the recovery.

We'll have more on what the future holds for the global economy, following the latest turmoil, in this week's issue of MoneyWeek, out on Friday.

And before we go, just a quick note on ETF Securities anyone who holds any of the exchange-traded commodities (ETCs) which were affected by last week's turmoil with AIG, will probably already know that trading has restarted in all of the affected products now. We'll have more on this, and ETFs in general, in Friday's issue too. If you're not already a subscriber,get your first three issues free here.

Also, we're hosting a webchat on emerging markets tomorrow at 13:00, with Michael Konstantinov of Allianz Global Investors and Mark Dampier of Hargreaves Lansdown. You can submit questions here - and watch the conversation live tomorrow.