The factors driving the Dollar seem to vary with the season. Last fall at the height of the financial crisis safe haven flows trumped all considerations; at one point investors accepted zero return for the security of holding US debt. The Dollar rose 17% against the Euro in a month and made similar gains versus the Pound Sterling, the Canadian Dollar, the Swiss Franc and the Australian and New Zealand Dollars. But even at maximum market panic Dollar superiority was not total; the imploding Yen carry trade drove the Dollar down against the Yen to 90 to the Dollar despite the huge inward flows to US securities.

The Dollar’s virtues last fall were very specific; in a catastrophe everyone’s first choice for safety was American debt. The Dollar’s competitive value was not the point, only its supposed security mattered. But those conditions could not last, and as the financial crisis became an economic crisis and the threat of financial system collapse waned the fear of wholesale loss of investment principal ebbed. In moderating circumstances the funds that had been stashed in the States for safety (and little or no return) began to be withdrawn seeking other more productive currencies and investments.

The degree of panic into the Dollar last fall guaranteed a correction out of the Dollar; but until the recent move that began on May 20th, the Euro had stayed below the 38% Fibonacci retracement level of the July to October 2008 collapse.

The Euro-US dollar equilibrium held from mid March until mid May with the pair largely confined to the range of 1.3100 and 1.3600. The original burst through that range on March 18th and 19th was prompted by the Federal Reserve announcement that it would buy Treasury Notes in an effort to keep consumer and mortgage interest rates low; this was the so called ‘quantitative easing’ policy. The Federal Reserve Board knew that the amount of US debt scheduled for sale to the credit markets in the months ahead could undermine its low rate policy.

Mortgage rates are not set by Fed fiat but take direction from the credit markets and one of the important market benchmarks are US Treasury rates. The initial market reaction to the Fed quantitative policy was extremely negative for the Dollar with the Euro gaining seven hundred points in two days. But despite the Fed announcement traders seemed to forget, the market absorbed that news and the Dollar regained all that it had lost after March 18th.

Enter the budget of the new American administration and its blueprint for the US economy. Treasury rates at the long end of the yield curve have been rising since March. The ten year note has gained 1.5% in yield in that time. The bond market clearly anticipated the impact of the government’s financing plans well before the actual auctions began. But the turmoil in the bond market did not dramatically affect the currency markets until last week.

In a classic economic comparison higher interest rates are one of the prime drivers of a currency’s worth. US rates are clearly headed higher, though not at the Federal Reserve level, but the Dollar has moved from strength to weakness. Gone is the Dollar support from the expectation that the US economy, under the spur of historically low rates and massive fiscal stimulus, will be the first industrial economy to leave the recession. Gone is the credit to the Fed’s early acknowledgement of the financial crisis and actions to mitigate the recession.

The correction out of Dollar assets will run its course. But the currency market focus on the amount of Fed quantitative easing, on the US deficit and future inflation, will remain. There is little confidence that a government as indebted as Washington will be able to withdraw the liquidity flooding the US financial system. The may even be the suspicion that Washington will realize that monetizing the debt is probably the only politically realistic course to alleviate the debt burden

The same proactive Fed and government policies that only a few months ago were seen as strongly supportive of the US economy and the US Dollar are now the Dollar's nemesis. The Treasury is the new driving force behind the Dollar’s fall.