Dollar weakness - long TBT?

From the Economist Down with the dollar:

The recession, which reduced America’s imports as consumers tightened their belts, has improved its trade imbalance, shrinking its current-account deficit. But ironically this has been accompanied by renewed weakness for the dollar.

The simplest explanation for the currency’s decline is based on risk aversion. On the days when risky assets fall, the dollar tends to go up. When risky assets rise, the dollar falls. The dollar has fallen fairly steadily since March, a period which has seen stockmarkets enjoy a phenomenal rally. Domestic American investors may be driving the relationship, repatriating funds in 2008 when they were nervous about the state of financial markets and sending the money abroad again this summer because of a perception that the global economy is reviving.

But although risk aversion may be a factor, describing the dollar as a “safe haven” seems dubious. Indeed, the weakness of American fundamentals has revived the longstanding bearish case against the currency. Some cite the American budget deficit, expected to be 13.5% of GDP this year.

But if foreign investors are so concerned, why is the dollar’s decline not accompanied by a sharp rise in bond yields? One reason may be that the Federal Reserve has been buying so much of the year’s debt issuance, as part of its quantitative easing programme. That has helped to keep yields down.

A simple dynamic may be at work: supply and demand. Last year the market was short of dollars because investors needed the American currency to meet their liquidity needs. This year QE is creating a surplus of dollars (and pounds) and is thus driving both currencies down.

The use of QE also creates a problem for central banks as they contemplate their exit strategies. An early abandonment of the approach could cause bond yields to rise sharply, unless there is an unexpectedly dramatic improvement in the fiscal position. But continuing QE could cause further currency weakness.

It is hard to see what the American authorities could do to bolster their currency even if they wanted to. Low yields offer little support to the dollar.

A country heavily in debt to foreigners, with a government deficit it is making little headway at controlling, is creating vast amounts of additional currency. Yet it is allowed to get away with very low interest rates. Eventually such an arrangement must surely break down.