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US POLITICAL TURBULENCE HITS DOLLAR

DIRECTOR OF CURRENCY RESEARCH, GFT

DURING times of stress in the markets, the dollar generally rises as risk averse investors flock to the safety of the world’s reserve currency. However, that dynamic could be reversed if the political problems in Washington are not brought under control.

Last Friday, news that Fed chairman Ben Bernanke may not be confirmed for his second term sent US stocks sharply lower. Typically when equities decline the greenback rises, but that day most equities and the dollar fell as political turmoil gripped the markets. At the moment, US policymakers appear to be on the verge of disarray – a situation that could bode badly for the dollar this week.

Bernanke has become the latest victim of the anti-incumbent sentiment sweeping across the American political landscape. In addition, the electorate appears to have grown extremely frustrated with the slow policy response to the worst economic recession in the post-war era. Even if he is reappointed, his reputation may have been damaged while his control over monetary policy could be constrained.

Meanwhile, President Obama has seen his own political capital diminish. As I’ve said before, currencies are first and foremost political, rather than economic, instruments – they depend on market confidence for their viability. Last week, the problems in Greece were the driving force behind the euro’s weakness. This week the same dynamic may affect the dollar.

Political turbulence is anathema to the markets. If currency traders perceive Obama as an ineffectual leader, the euro could rally despite increasing evidence of a slowdown in economic activity in the Eurozone. That’s why tonight’s State of the Union address may be of particular importance to the market. If Obama can reassert his authority, the greenback should reclaim its safe harbour status. But if not, FX markets may have to get used to the idea that the dollar no longer offers protection from risk.

Boris Schlossberg and Kathy Lien are directors of currency research at GFT. Read daily commentary at www.GFTUK.com/commentary or e-mail them at BorisandKathy@gftuk.com.