The worse the US does, the better the dollar does ...

The dollar hasn’t fallen along with the US stocks, US Treasury yields or US employment. There is now a broad consensus that the US is currently in a recession, something that might be expected to lead to a fall in the dollar.

But the dollar, instead, has rallied. Against the euro. But also against a host of Asian currencies and commodity plays like Brazil and Russia. And it is soaring against the Icelandic Krona ...

Some have called this a flight to quality. That though doesn’t seem quite right. The US is the source of much of the bad debt that has brought the world’s financial system to a near-standstill. The default of a US institution -- Lehman -- triggered the current panic in the shadow financial system. The price of "insurance" against the risk of a US government default suggest that US government debt is now considered a bit more risky than German government debt.

Rather this seems to be a flight away from risk.

Remember, the dollar rallied last August too, for the exact reason jck of Alea highlights.

Of course, there is now a new dynamic at play as well -- namely mounting evidence of a broad global slowdown, and a sharp slowdown in Europe. That is quite different from last August, when the US slowed and the world didn’t. The dollar has to have something to depreciate against ... and right now there aren’t many good candidates.

But there is also reason to think that the dollar’s current strength reflects something other than the United States relative economic fundamentals. A recent research piece from Sophia Drossos and Yilin Nie of Morgan Stanley argues that global deleveraging is a major current source of support for the dollar.

Drossos and Nie note that US banks have grown reluctant to lend to banks abroad -- and many banks abroad have significant holdings of dollar debt and thus need dollar financing.

"increased issuance of US debt (partly due to the securitization boom) has resulted in foreign[er]s increasing their holdings of US debt. These USD denominated assets need to be funded in USD. Even under normal circumstances, there is a limited supply of USD overseas. The natural sellers of USD in global funding markets are US based banks with large deposit bases. But in times of heightened market frictions, banks are reluctant to lend at all given the increased uncertainty about their own funding needs. As US-based institutions have scaled back their overseas lending, the premium for USD LIBOR has increased significantly."

The solution to a world where US banks won’t lend to the global funding market? Simple, the US central bank lends dollars to European central banks who lend dollars to their banks -- dollars that European banks can no longer get from US banks. Call it cross-border central bank intermediation. this is why the Fed has, in some sense, become a global lender of last resort.

Drossos and Nie also highlight a dynamic that observers of currency markets know well -- a carry trade unwind.

"USD has been a low-yielding currency for some time, and US policy rates are now the second lowest in the G-10 [Setser note, after Japan] -- a fact often overlooked by market participants. The US-specific nature of the slowdown in H1 2008 likely only fueled expectations that rate differentials would continue to move against the USD. Our sense is that this had two major consequences: (1) an increased amount of FX carry trades began to be funded in USD over the course of last year; (2) US based investors increasingly sought higher returns abroad."

In other words, the US became the new Japan after the Fed’s rate cuts -- despite a large current account deficit. And the US dollar has started to act like a "funding" currency in times of stress. And in general, when risk aversion goes up and risky bets are pulled, funding currencies rally ...

The net result, though, has been rather surprising in a lot of ways: dollar strength amid US economic and financial weakness. I at least don’t think we really know what the long-term impact of the current crisis will be on the dollar. Zhou Enlai’s classic quip about the French revolution applies with force.

We still don’t know what will happen once the forced buyers of dollars by actors scrambling to repay dollar debts ends. The US will likely still have a sizeable external deficit that needs to be financed for a while longer, which could drag the dollar down. On the other hand, the US won’t be the only country in a recession. Rather than competing in a beauty contest, the dollar is the United States entry into a competition that will be "won" by the country considered to have the least ugly currency in an increasingly grim world.