Dog Days for the Dollar

The US treasury secretary, Paul O'Neill, may now be wishing he had invoked his constitutional right to "take the fifth" when he appeared before the Senate banking committee on Wednesday. Silence in this case could have been golden.

For the past decade, treasury secretaries have played an elaborate parlour game when giving testimony on Capitol Hill. Asked to explain policy towards the currency, the mantra has been: "A strong dollar is good for the US economy." Staying silent in the face of further questioning may have been mind-numbingly tedious, but it helped keep the speculators at bay.

Having declared that he did not want to give the speculators any "ammunition", blunt-speaking Mr O'Neill proceeded to hand the markets a loaded gun.

The words of politicians mattered far less than the performance of economies, he said. "I think there's a real doubt about the effectiveness of interventions or words about intervention."

As a statement, it was hardly earth-shattering in its wisdom. But it was taken as a sign that he was diluting the Bush administration's commitment to a strong dollar in the face of mounting pressure from manufacturers in the rustbelt states struggling to compete in global markets.

As such, it was enough not only to provoke a wave of selling that took the dollar to its lowest level for six months against all major currencies but also to prompt speculation that its seven-year bull run on the foreign exchanges was coming to an end.

"People are starting to see cracks in the strong dollar policy now, which makes them at least moderately bearish towards the dollar," said Jeremy Hawkins, of Bank America in London. "Paul O'Neill's testimony yesterday suggested he's inherited this strong dollar mantle but doesn't really want to wear it."

To be fair to Mr O'Neill, the market was already looking for another excuse to dump the dollar after five turbulent years in which the currency has been the safe haven of choice for global investors. The response to the Asian financial crisis of 1997? Buy the dollar. What to do after the euro's less than sparkling debut in 1999? Load up with dollars. Even the September 11 terrorist attacks failed to shake the faith of the markets.

Gerard Lyons, chief economist at Standard Chartered, said there were two main strands to this approach. "Either investors took the view that whatever happened to the US economy the outcome would be worse elsewhere, or they had complete confidence in Alan Greenspan and the Federal Reserve's policy response."

So what's changed? If anything, the US appears to be again outperforming the rest of the world. The 11 interest rate cuts in 2001 meant the economic downturn was shortlived, with fears dispelled that September 11 would deepen and prolong the recession initially caused by the puncturing of the stock market bubble. Share prices rallied quickly in the autumn in anticipation of a corporate profit bounceback.

But then something odd happened. In the first three months of 2002, there was lots of encouraging news about the US economy and plenty of bad news about its leading trading partners, Europe and Japan. Yet the dollar did not strengthen on the foreign exchanges. That in itself was a sign it was running out of steam. But in the past month, there has been a series of events that would once have proved destabilising for the euro.

There was a general strike in Italy, the Dutch government resigned, Germany's largest union, IG Metall, threatened to strike over pay, and then Jean-Marie Le Pen stunned Europe's political elite by defeating Lionel Jospin in the first round of the French presidential elections.

Those who went short of the euro in anticipation of a big selloff have had their fingers burnt. Far from plunging towards its all-time low of $0.8230 seen in the autumn of 2000, it has risen above $0.90 and seems poised to go still higher. David Brown, chief European economist at Bear Stearns, said: "There are a couple of tripwires ahead for the euro, such as the second round of the French elections. But once Chirac is back, it's all clear for the euro to trade quickly back up to parity against the dollar by the end of the year."

The European Central Bank is already hinting that it might put up interest rates - but whereas such a move two years ago would have had investors piling into the dollar, this time it may boost the euro.

One central banker said recently that it was back to business as usual in the foreign exchanges, with investors again focusing on the interest rate yield on offer from rival currencies rather than their respective growth potential. When the Canadian central bank raised interest rates last month, the Canadian dollar, which was on the floor for most of last year, started showing signs of life.

According to Mr Brown, foreign exchange dealers see signs of tighter monetary policy around the world, with two big exceptions: Japan, where a lower yen is the government's only real weapon against permanent recession; and the US, where the Federal Reserve is concerned that much of the recovery in the economy in the first quarter was simply caused by restocking and that a prolonged period of low interest rates will be needed.

The performance of corporate America justifies that caution. One company after another has come up with disappointing earnings figures in recent months, and that has been reflected in the weakness of the stock market. With Wall Street now into the third year of a bear market, the argument that the US always provides better returns is no longer convincing. Instead, attention is turning to the fundamentals of the US economy, where the gaping current account deficit, now 4% of output and rising, is the main cause of concern.

The US's relaxed attitude towards the deficit has met with mounting international criticism in recent weeks, with Wim Duisenberg, the president of the European Central Bank, the latest to warn that growing imbalances could destabilise the world economy.

The Federal Reserve's own research shows that when a current account deficit hits 5% of output it has always led to a precipitous decline in the currency. The other great mantra of treasury secretaries has been that the fundamentals of the US economy are sound. Mr O'Neill repeated the magic formula on Wednesday, but the illusion appears to have stopped working.

If the current account deficit continues deteriorating at its present rate, by the end of next year the US will have to suck in $1bn a day from overseas investors to cover the shortfall. On recent form, it is more likely the dollar bubble will burst first.