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I have lost count as to the number of comments I have received that show no concern as to the level of the dollar. The argument is that the dollar is merely back to the same levels as it was in 1995 and that there is no cause for concern.

This shows a lack of understanding as to how markets work. It is like telling someone who bought the SPX at 1450 that there is no cause for alarm given that the futures have rallied back to 1120 from 850 for a 31% rate of return. The person who bought the market at 1450 doesn't give a whit about that 31% rate of return: she is down 22% on her money.

It is not the absolute level of any market that really matters: that is only a fraction of the story. What really matters is what has happened in between levels.

The reason the dollar, as measured by the DXY index (an index weighted by the level of trade transacted into various currencies) rallied from these levels in 1995 and then again in 1998 to a high of 120 by March 2002, by definition is that foreign capital flowed into our country. Foreigners sold us goods for dollars and turned around and bought U.S. assets: some hard assets, but predominately financial assets like treasury bonds.

Based on the amount of money supply created during this time relative to that which was created previously, we can safely assume that the amount of dollars held by foreigners increased dramatically during this time. If we are conservative and assume that most of this dollar buying was done at an average of 110 over the last three years, this means that foreigners have lost approximately 22% on their dollar investment.

So even though the nominal level of the dollar is around the same as it was in 1995, because foreigners increased their exposure to dollars at higher levels, much damage has been done from their perspective.

Most foreign governments have now turned net sellers of dollars. Even China over the last few months has been a net seller of dollars. This is a natural and logical reaction given that they are down on their investment and that the decline in the dollar (which has declined little against Asian currencies) has done almost nothing to improve our chronic trade imbalance. Perhaps this is why the Fed is doing everything it can to convince us now that the trade imbalance is not a problem as long as it continues to be financed.

I will readily agree that it is not an actual problem now, but it certainly is a potential one. The last buyer of U.S. dollars and U.S. financial assets seems to be Japan. If they turn and run, the problem then could very well turn actual and the Fed may run out of excuses.

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