An unfashionable time to be the dollar

If this were the late 1980s we would be waiting for a bout of central bank intervention to boost the dollar. Remember the days of the Louvre Accord of 1987, when the leading industrial countries agreed to hold currencies within unpublished bands, so that if one rose or fell too far their central banks would intervene to push it the other way?

Those days seem long past. The central banks still have their monthly meetings in Basle, the finance ministries still talk to each other at international meetings, but they don't talk much about currencies. The fact that the dollar has been driven down in recent weeks has not provoked the concerned reaction it would have caused five years ago. Does this mean that the central banks are no longer worried? Or will they pounce soon ?

There are two tests which need to be applied to any sudden currency movement for it to become a candidate for intervention. The first is whether the movement is irrational - because if it were justified by the underlying economic situation it would be absurd to try to offset the shift. The second is whether it is likely to destabilise the world economy - if it does not matter too much, the central banks are unlikely to want to become involved.

The best answer to the "Is it rational?" test is "not really". One of the less attractive aspects of market commentators is their ability to create rational reasons why something should have happened when they had previously failed to spot that it might happen. And so they rounded up the usual suspects to explain dollar weakness. These include US financial commitments to Mexico, a perceived (and probably wrong) reluctance of the Fed to move interest rates up much further as the US economy slows, the sharper-than-expected rebound of the German economy (which increases the likelihood of an early increase in mark rates and so increases its relative attraction).

The trouble is, none of these are really credible. The US support for Mexico, whatever it costs, will be modest beside the West German support for the former East Germany. While the US expansion is certainly mature, the economy is going to continue at above-trend growth for at least another six months, which would certainly justify further rises in US interest rates. And as for the "flight to quality" which is supposed to justify putting money into marks rather than dollars, on rational grounds dollars ought to be more secure than any European currency, for there is a possibility that the European currency might disappear in the next five years, whereas there is no such possibility for the dollar.

No, the real explanation is fashion: the dollar is unfashionable. There are times when markets ignore fundamentals and follow their whim. So many people (myself included) have confidently predicted a dollar recovery and been proved wrong, that people have started to lose confidence in their judgement. That is, of course, just the moment when markets turn - when everyone is convinced that they will never do so - but the dollar's recovery has been a long time coming.

The best answer to the "Is it destabilising?" test is "not yet". One could envisage a fall in the dollar which would start seriously to damage world trade, but it would have to be more marked than the present weakness. The experience of living for more than 20 years with fluctuating currencies has made companies much more robust: not only are there many more financial instruments available which enable companies to hedge their exposure; many firms have adapted their structure (for example by setting up assembly plants close to their markets) to render them less vulnerable to currency swings. As a result, the central banks are not yet seriously concerned. There will be a dollar rate which would cause such concern, but it is probably below DM1.40. In any case there is only some point in the central banks using their principal weapon to order the exchanges, concerted intervention, when the markets are already sniffing at a turning point. Intervention only works when it pushes the markets into doing something they wanted to do anyway. A somewhat half-hearted bout of support of the dollar last autumn failed on this score.

All this suggests that the turning point for the dollar, helped maybe by intervention, is some months off. Now, what are the implications for sterling? The pound has been hit by similar worries, and the markets have rounded up the usual suspects. Some of these are political. It is not just that the markets fear that the next UK Government will be led by Labour; it is also that in the run up to the election the Tories will make mistakes. The reality is that no-one knows very much about Labour financial policy, even on fundamental issues such as a single currency.Nevertheless, it would be absurd to deny that the markets are concerned about the direction of UK politics.

In the absence of an early general election there are two things which might change the mood about the pound. The first would be that turning- point for the dollar. The two currencies have tended to move in much the same direction and when the dollar does recover its fashionable status, as it surely will, that will help sterling.

The second is a continued run of good economic numbers. One of the problems at the moment is that the combination of some slight weakness in the pace of economic growth and the more marked weakness of the Government has led to feelings that the authorities will be reluctant to increase interest rates much further. If the economy's performance figures continue to behave and the authorities are prepared to continue their anti-inflationary stance, then fundamentals will reassert themselves. But, do not expect a sterling recovery just yet.