Dollar Dust

Crossing that bridge
With lessons I've learned
Playing with fire
And not getting burned
--Seal

The Fed's actions this week to accept risky mortgage paper as collateral from financial institutions in exchange for Treasuries has been crushing the dollar to new lows. Having trouble connecting the dots? The Fed puts junk on their balance sheet. If the junk goes down in value, the Fed could a) take the loss and perhaps go bankrupt b) print money to make up the difference.

The market whiffs b)...more potential dollar supply and, voila, greenbacks get sold.

Some are suggesting that a stronger economy will cause the USD to rise despite these clearly inflationary efforts. Hard for me to see.

Instead, I think the best case for a dollar rally is if folks determine that none of these interventionist policies will stave off recession. If people recognize this and become risk averse (hoard cash, pay down debt, unwind risky positions), then demand for dollars should increase.

This, of course, is the deflation scenario. Should this come to fruition, risky asset prices should fall as the dollar rips higher.