The Wall Street Journal-20080128-Ahead of the Tape

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Ahead of the Tape

Full Text (541  words)

Is U.S. Dollar

Slowly Turning

Into the Yen?

The U.S. financial crisis is starting to look eerily like Japan's: a real-estate bust after years of speculation, banks saddled with mountains of bad debt, interest rates heading lower as policy makers try to goose a slowing economy.

The developments have some currency traders asking the previously unthinkable: Could the U.S. dollar slowly be turning into the Western equivalent of the yen?

Other central bankers have been reluctant to act as the Fed slashes interest rates. In places such as Europe, they are worried more about inflation than economic collapse. The disparity in policies could turn the dollar into one of the world's lower-yielding currencies -- and a vehicle for something that investors call the carry trade, in which they borrow money in a low-yielding currency and use it to invest in assets denominated in higher-yielding currencies.

Japan's yen has been the carry-trade vehicle of choice for years, given the country's superlow interest rates. The Swiss franc has been another. If the Fed keeps cutting rates, carry-traders might line up to ride the dollar like a birthday pony, with important implications for markets and the economy.

"The dollar is now generally looking like a low-yielder," says Alan Ruskin, international strategist at RBS Greenwich Capital. "If the fed-funds rate got below 3%, it would establish itself as that."

If the dollar becomes a carry-trade object, the Fed's job would become more difficult. Carry-trade currencies face steady selling pressure -- traders are essentially betting against the dollar. A weak dollar could in turn keep inflation risks alive, by raising the cost of imports. But Fed rate increases to fight inflation would threaten economic growth and potentially cause waves of market turmoil with all manner of trades pegged to the currency.

There are good reasons to doubt this scenario. If economic pain overseas deepens, foreign interest rates will likely come down, too, closing the gap with U.S. rates. This is one reason the dollar didn't become a carry-trade currency when the Fed cut its target rate to 1% after the 2001 recession.

The U.S. economy and its banking system have been more adaptive to crises than skeptics expect, and so is likely to adjust quicker than did Japan. Trade is another determinant. The U.S. runs a longstanding trade deficit -- with imports outpacing exports -- that is financed by foreign investment. Dollar weakness could inspire high investment returns that keep luring foreign investors and prop up the currency. Moreover, because foreign governments already have trillions of dollars in reserves and so much global trade is conducted in dollars, lots of players have a big stake in keeping the buck from becoming a host body for carry-trade parasites.

"There are built-in mechanisms to prevent the dollar from being the new funding currency," says David Gilmore, of Foreign Exchange Analytics, a research firm.

Yet crises tend to usher in big changes in the financial system. Japan's banking crisis set it up for more than a decade of superlow interest rates. Emerging-market crises in 1997 and 1998 set the stage for their huge buildup in foreign-exchange reserves. By the time the U.S. banking crisis is resolved, the dollar might look nothing like it does today.

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