Will the US dollar recover?

The US Dollar continued to strengthen last week, reaching 10 week highs against other major currencies. As a result, the European markets moved to new highs once again and the US and US linked markets fell. In fact, the European shares notched up a 30-month closing high last Friday on the Dollar move as well as slightly weaker-than-expected US employment data, which soothed interest-rate worries.

We do note however, that the US Federal Reserve did come out this week with an announcement reminding investors that they never pledged to hike interest rates only at a measured pace, just that they expected to. The US Fed is closely watching inflation, a top policy-maker said Monday, indicating that if necessary, they would raise rates faster to curb inflationary issues. Last week, we offered an opinion regarding the moves we expect over 2005 in the international currencies. We see the US Dollar dropping to around 90 Yen by year end and weakening against other major currencies as well. An exchange rate of 2.0 to the GB Pound and 1.40 to the euro would be our estimates for year end for the USD on those two currencies.

Of significance is the Chinese RMB currency which is pegged to the USD. Thus a falling dollar does not make Chinese products more expensive in the United States. Remember, the US government has created the largest swing in history in its income statement, moving from a surplus to a major deficit. A weaker dollar and inflation (which lowers the amount of debt in real terms) are both movements which benefit the US trade imbalance and high debt.

Back to Normal?
The recent gains by the US Dollar over the past few weeks may have some persons thinking that the greenback will get back to “normal,” normal being that range in the recent past that they remember. We would caution such a view. People and investors often get caught believing that a recent trading range is where the level should be. Thus they expect it to naturally return to that level. In December the value of the dollar touched an all-time low against the euro. In fact, the dollar’s been dropping steadily since 2002 and is now worth 35% less vs the euro than it was back then. Should it recover? Well, maybe we have just seen a necessary correction. The dollar went through the roof in the late 1990s because the US economy boomed as growth in the rest of the world stalled. So is this move adjusting for that excessive gain?

The international currency market can be dazzlingly complex, and experts can argue endlessly about what’s really driving the US Dollar’s decline and where it should trade. The strength of the country’s currency relates to its economic strength, just like a person’s bank credit rating. The more healthy you are financially, the stronger your currency against others. But, as we have explained in earlier articles, it can be looked at quite simply, just like an individuals personal life. An individual can spend more than you make for a short time, borrowing from banks, friends family or slowing the payment of bills to increase the cash to spend elsewhere. But obviously, this can not go on forever.

The same is true for a country, and as it relates to the good ol’ USA, in the eyes of the rest of the world. Americans are starting to look like savings-challenged, credit-addicted materialistic gluttons. Americans consume more stuff from outside their borders (imports) than they sell back (exports) resulting in an annual trade deficit set to top $600 billion for 2004. Consumers have racked up $2 trillion in consumer debt (ie they borrowed money to buy the stuff), the federal budget deficit stands at over $400 billion (ie the government is spending more than it makes) and the national debt is currently $ 7.6 trillion USD. The overall external net debt position is 2.6 trillion, that is to say, since moving from a trade surplus situation, the US has accumulated 2.6 trillion in trade imbalance (they have bought 2.6 TUSD more imports than they exported).

Not Bad
But, the figures are not that bad when considering the % basis. Further, the formula that future growth will pay back the temporary borrowing also seems to be working, the worst seems to be over, especially as it relates to the US Dollar exchange rate. The budget deficit, that is the amount of money the US Government is spending which is more than it earned, is USD 400 billion but that is less than 5% of the 11 trillion plus country’s GDP (the country’s total income). If you were to borrow 5% of your income stream to invest in expansion of your income, it doesn’t look so bad. Same is true for the current account deficit, which is the external trade imbalance. Right now, the USA’s USD 600 billion excess in imports is only 5.5% of the 11 trillion plus country’s GDP. Again, a figure that is not too bad considering the % look.

That said, it is principally the current (trade) account deficit that is really driving the dollar lower. Almost all the depreciation in the Dollar seen thus far has been against the European and commodity based currencies and not against say China or the smaller East Asia currencies. And as we have discussed before, the Asian Central Banks are willing to hold US Dollars in exchange for keeping their currency value down.