Source:
http://www.nytimes.com/imagepages/2008/09/28/weekinreview/20080928_MARSH_GRFK.html

"Summary and Conclusions

Conventional wisdom has it that, as a government fiscalises the contingent liabilities of nationalised banks, the currency of the country in question should depreciate. More generally, banking crises are, very often, accompanied by balance of payments (or currency) crises. The US, being a country with still out-sized ‘twin deficits’ (fiscal and external deficits), will likely see the dollar weaken because of the Treasury and the Fed’s decision to effectively nationalise some of the large financial institutions, so the argument goes. An inconvenient fact, however, is that nationalisation of banks, historically, did not tend to lead to further currency weakness. In fact, very often the financial sector and the currency in question reach a trough just as the government takes steps to address the banking crisis. Thus, currency weakness tends to precede, not follow nationalisation.

Popular Thesis on Nationalisation and the Dollar

The notion that nationalisation of banks should lead to currency weakness is popular mainly because it is intuitive. Since nationalisation of banks is ‘not good news’, and runs counter to the principles of capitalism and the free market, some have the visceral reaction to sell the currency in question.

Further, as highlighted by Kaminsky and Reinhart (K&R) (see Graciela Kaminsky and Carmen Reinhart (1999), “The Twin Crises: The Causes of Banking and Balance-of-Payments Problems”, The American Economic Review 89: 3, June), there are many historical examples of ‘twin crises’, whereby banking crises and currency crises occurred simultaneously. The more memorable examples include Argentina in the early 1980s, Sweden and Norway in the early 1990s, Japan in the late 1990s and Thailand in the late 1990s. In fact, K&R found that, during 1980-1995, of the 23 banking crises, 18 were accompanied by balance-of-payments crises.

This link between banking crises and currency crises is genuine, and the usual dynamics are well-summarised by ex-Governor of the Riksbank (Sweden’s central bank) Mr. Bäckström (see What Lessons Can Be Learned from Recent Financial Crises? The Swedish Experience, Kansas City Fed Seminar in Jackson Hole, August 1997): “Credit market deregulation in 1985 … meant that the monetary conditions became more expansionary. This coincided, moreover, with rising activity, relatively high inflation expectations, … (T)he freer credit market led to a rapidly growing stock of debt… The credit boom coincided with rising share and real estate prices… The expansion of credit was also associated with increased real economic demand. Private financial savings dropped by as much as 7 percentage points of GDP and turned negative. The economy became overheated and inflation accelerated. Sizeable C/A deficits, accompanied by large outflows of … capital, led to a growing stock of private sector short-term debt in foreign currency”. This description applies quite well to the US right now.

Moreover, nationalisation of banks will increase the fiscal burden of the government. For a country that already has a large fiscal deficit, this is clearly negative for the interest rate outlook. For one that also has an external deficit, a large public borrowing need, ceteris paribus, should translate into a weaker currency, so the logic goes. At the same time, the central bank may be tempted to ‘monetise’ the debt, or run a monetary stance that is easier than otherwise – again currency-negative.

The Inconvenient Historical Fact

While the arguments above may sound logical and compelling to many, the inconvenient fact is that the historical pattern of how currencies perform before and after nationalisation or bail-outs tells a very different story. Averaged across five episodes of prominent banking crises, the nominal exchange rate tended to fall before nationalisation, but rise thereafter.

The historical pattern suggests that financial markets tend to be forward-looking and try to price in the deterioration in the state of the banking system by selling down the currency and financial sector stocks, but the government is usually not compelled to act until conditions deteriorate significantly. As a result, more often than not, government interventions have coincided with the lows in currency values. In other words, even though K&R’s observation that currency crises often occur simultaneously with banking crises is correct, there is no strong proof that nationalisation leads to further currency weakness.

Other more visible examples are consistent with this link between banking crises and currency crises. The S&L Crisis and its bail-out spanned a protracted period of time. The dollar index did continue to fall from 1986 – the beginning of the S&L Crisis – until 1989 or so. (In 1986, the FSLIC (Federal Savings and Loan Insurance Corporation) – the deposit insurance scheme funded by the thrift industry but guaranteed by the government – first reported being insolvent (incidentally, the main reason why 1986 is remembered as the beginning of the S&L Crisis). The RTC (Resolution Trust Corporation) was established in 1989, and by 2003, the RTC had ‘resolved’ US$394 billion worth of non-performing assets of US savings and loans. (The total cost of the clean-up of the US S&L Crisis reached US$153 billion, in ‘current’ terms equivalent to some 2.6% of US GDP in 1991. This translates to US$375 billion in 2008 dollar terms.) The dollar index essentially moved sideways in the early 1990s. The dollar did falter in 1994/95, but that was attributed more to the inflation scare than to the S&L Crisis. Similarly, Japan’s government did not explicitly address its banking crisis until 1998-99 and again in 2002-03. After each episode, USD/JPY actually collapsed toward 100, i.e., JPY strengthened in the ensuing quarters. Finally, in the case of Thailand, the banking crisis did indeed lead the currency crisis. But bank bail-outs did not take place until 1998, and USD/THB drifted in the 36-42 range between 1998 and 2000 – significantly below the peak of 56 reached in January 1998.

The case of the US at present is also illustrative. Between the onset of the credit crisis in August 2007 and the collapse of Bear Stearns on March 16, 2008, EUR/USD rose from 1.35 to 1.58, and lingered around the latter level as the Fed and Treasury assisted other financial institutions in the subsequent months. Since July, EUR/USD has collapsed from 1.60 to a low of 1.39 last week. Even with recent dramatic events, there is no evidence that ‘nationalisation = currency weakness’. If anything, the dollar has held up remarkably well this week, despite several dollar-negative factors, including: (i) a higher probability of the Fed cutting the FFR than the ECB reducing the refi rate; (ii) a diluted Fed balance sheet, from the substitution of US Treasuries for other lower-rated securities; and (iii) large increases in the future fiscal burden of the US, from the contingent liabilities that are fiscalised. In fact, the only dollar-positive factor this past week was lower oil prices. EUR/USD seems to be drifting back toward 1.45, but we see this move as rather innocuous, given the severity of the financial stress in the US.

In sum, banking crises are unambiguously bad for currencies, but nationalisation per se does not make the situation worse for currencies. In fact, it often marks the low in the currencies.

The US Fiscal Worries Over the Medium Term

Having said the above, the US does have quite a worrisome fiscal outlook in the years ahead, which may eventually have an impact on the dollar. Setting aside the issue of the fiscal burden associated with the assistance the official sector has provided the financial sector, US expenditures may be too high and revenue buoyancy may be undermined by the weak equity and property markets.

The Congressional Budget Office (CBO) released its budget update last week, and predicted that the US federal deficit will rise from US$161 billion (1.2% of GDP) in 2007 to US$407 billion (2.9%) in 2008. This sharp deterioration in the fiscal balance reflects a simultaneous increase in spending and a decline in tax revenues. (Total government spending will increase by US$226 billion, to close to US$3.0 trillion, reflecting both discretionary and mandatory spending.) The CBO forecasts that deficits will remain above US$400 billion in each of the next two years.

Investors will likely see it as key for the next Administration to control spending. However, it is also important for investors to appreciate how sensitive US revenue collection is to GDP. During 2001-02, for example, as the US economy fell into a brief recession, revenue collection plummeted from 21% of GDP to close to 16%. Thus, the strength of the US economic recovery in the coming years will have important implications for the overall budget position. These fundamental trends in revenue collection and ‘core’ spending are at least as important as the costs associated with nationalisation. The performance of the dollar in the coming years will, therefore, be a function of how the US government deals with spending and how rapidly the US economy recovers, in our view.

Bottom Line

Banking crises are bad for currencies, but nationalisation per se does not necessarily make it worse for currencies. In fact, it often marks the low in the currencies. We believe this is the case for the dollar in the current episode. What remains a lingering risk for the dollar over the medium term is the US fiscal position, unrelated to the costs of nationalisation."

Source:

http://www.morganstanley.com/views/gef/archive/2008/20080919-Fri.html#anchor6931

"This held that the dollar had a “convex” relationship to US economic growth.

On this theory, if the US economy goes into a severe decline, or hard landing, then the dollar should rise. The rest of the world suffers, and the dollar is a relative safe haven.

If the US economy goes on a growth spurt, outpacing the rest of the world, the dollar gains.

But between these two outcomes lies a “soft landing”, where the US economy muddles through. If this happens, the dollar gets pummelled. Other countries have higher interest rates, and there is nothing to defend the dollar."

Source:
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Who is Stephen Jen?

US Dollar Index is hitting multi year important technical level too fast too soon. Market really priced in Trichet comments pretty heavily. But also, don't forget to analyze EURUSD vs. USDCHF (98% inverse correlation).

EUR/USD dropped too fast. It was really unexpected. What a single day drop! Now, it should stabilize @ current shown level @ 1.50USDCHF trying to break multi year trend line. Can it break? By looking @ EUR/USD, if it doesn't fall further, USDCHF will go sideways from here.

No clear signal to buy EUR or CHF yet, but "SCALPERS" you can take small profit from 1.5077 to 1.5000 for EUR/USD.

This is chart of US Dollar Index (daily). As you can see, it has broken short term channel, but immediately after that there are two important trend line levels. You might hear & read in main stream media that there is a shift in Greenback sentiment, but to me there cannot be US Dollar bull until it breaks these two shown barriers. This is just a short term bull for US dollar by looking @ this chart.
This second chart (daily) is about currency futures comparison. So far, we have seen lower highs in JPY & CHF futures, but not in AUD & EUR futures. And on US Dollar, there isn't higher high yet, therefore it is hard to tell that medium-longer term bearish US Dollar sentiment has shifted to bull.This 3rd chart is GOLD/USD daily chart. It has made lower high, but it's still holding thick brown trend line. I am not expecting US Dollar bull, if GOLD reverses from here.

Conclusion: US Dollar is right now at very important level of make or break, but no clear
signals yet. Fundamentals for US economy are still very weak. Europeans are
slowing down (German Factories), but AUD is still solid. However EUR & NZD are
dragging AUD down. Friday's COT report might show some interesting sentiment
for next week. Stay Tuned...

This chart has 1 year high-low projected Fibonacci Resistance. Level 23.6 which is minimum pull back is @ 1282 which closely matches with last extreme high-low fibonacci analysis done in previous post at 38.2 level on 1284. So it's very high probability that SPX is atleast going to 128- level.

Second chart is about % ratio analysis between Dollar Index(blue), USD/JPY(Black), SPX(Brown) for short term. Since there was a clear divergence between USD/JPY & SPX we knew that SPX has to follow trend of USD/JPY. I am not expecting USD/JPY to break thick blue (ver strong support, level 108)horizontal line, due to strong bearish fundamentals on USD & market expectation of Bank of Japan to raise interest rate soon.Possibility 1:
USD/JPY stays @ purple trendline and reverses = SPX near 1276 & possible reversal

Possibility 2:
USD/JPY stays near blue horizontal (very strong) support line near 108 = SPX near 1290 & possible reversal.

Possibility 3:
USD/JPY stays near blue support line(108) & SPX goes near 1311 that will be strong reversal territory.

• USD/JPY is about to rise back to 108.30 level.
• VIX is about to fall to previous support level near 16.
• But SPX hasn't finished it's correction to near 1200(speaking from Trendline channel.)
• US $ Index is heading upward to 74 level which is bear for Crude & Gold.
• If you notice, currently there is a divergence going on between SPX & USD/JPY. Historical Correlation Ratio says that these two move in same direction between 80-90%, sometimes more than 90%.