Market Preview

        Sovereign debt continues to be the concern, enough so that even Geithner was asked if the U.S. would face a credit downgrade, "That will never happen to this country!" - he is probably right. Even though the U.S. may face a situation in which they "SHOULD" be downgraded, remember the same credit rating agencies are facing Congressional pressure for being part of the cause of the credit crisis - with their AAA ratings of mortgage back securities. I guess you have to ask yourself two questions - 1. Have the credit rating agencies ever been wrong? 2. Is there any conflict of interest in lowering U.S. credit rating? The answer to both those questions is obvious. While the three top tier credit rating agencies have not downgraded the U.S., a couple of smaller foreign credit rating agencies already had. While they obviously don't carry any weight - it was enough for China to continue to saber rattle last year.
                The dollar has seen serious volatility over the last year - the government's policies created serious weakness in the dollar over the last couple years - pushing the Western currencies higher. There was even talk - which has subsided - about the U.S. being dropped as a reserve currency. Several foreign central banks starting purchasing more foreign debt, gold, commodities and Russia, China, and Brazil bought billions in IMF debt as an alternative to U.S. debt.
                The U.S. has looked to have passed the worse of the recession and "seems" to be on the road to recovery and the talk of a new reserve currency has subsided. The action in treasuries has seen a slight increase by foreign central banks - it is important to remember the bulk of that investment is in short-term treasuries. Foreign Central banks certainly do not want to remain captive to long-term interest rates or the possible credit problems that remain below the surface of the U.S.
                There is also the "Carry Trade" which was primarily held in the YEN, which quickly changed to the U.S. dollar as interest rates went to zero. Now we are seeing some covering going on in the begging of the year - as the unwind "payback" is driving a good portion of liquidity. The problem that central banks face is that the U.S. is not the best place to be and they know that (they have openly vocalized that) - however it is the only place to be for a reserve currency. With oil and several other commodities still priced in (primarily) dollars - many foreign countries will have to hold U.S. dollars as it is the defacto currency for commodities and debt - including IMF.
                The ball is probably more in China's court as to how this game unfolds. Bloomberg showed that the change in their currency weighted basket of western currencies is little changed over the last decade, but we must remember that is weighted and traditionally we had not seen much volatility between foreign currencies. However, if we look at the short-term the dollar index has been significantly more volatile, just like interest rates.

The dollar faces several unknowns:
1.       Does it remain the official reserve currency? Even if it does, do foreign central banks continue to diversify out of the dollar?
2.       Do current monetary policies continue to weaken the dollar from its long previous low volatility status?
3.       Will the Fed raise short-term interest rates and will that bring strength back to the dollar or will it only off-set inflation?
4.       Will foreign central banks continue to hold only short-term paper, putting a serious unknown in the Fed/Treasuries ability to refinance the U.S. debt in years to come?

There are many questions - many will go unanswered - for now the dollar plays a huge role in the overall market volatility and conditions.

Bloomberg article shows almost no volatility in the dollar against foreign currencies in 35 years (3%), but in just the recent year we have seen currency moves between 10-25%. Add to that a record U.S. Debt and ballooning deficit - that volatility can continue. The current dollar policies from the Fed are "weak dollar" policies for sure - and that has been reflected in the dollar's steep drop and now higher volatility. However, it looks like Euro has its problem with Greece. The dollar maybe the only place to go for now - but just because it is doesn't mean it is the best place - especially at the current rates and the uncertainty of the U.S. credit rating (which we know may never face a critical eye by our own credit rating agencies).

Remember - how the Dollar performs against the Euro, doesn't mean inflation is or is not in the cards. Europe can face the same inflationary pressures this nation does. Do we easily forget the Realm Mark, Pound, and Dollars of the Great Depression?

http://www.bloomberg.com/apps/news?pid=20601087&sid=aVbhDaStbA1Q&pos=2