Why US Dollar Is Likely To Remain Weak for Awhile - Forex Currencies

[Monitor]

Why US Dollar Is Likely To Remain Weak for Awhile - Forex Currencies

Published by CNBC - November 2009

"Why the US Dollar Will Likely Remain Weak for Some Time" Albert
Bozzo, Senior Features Editor

The dollar is weak. Get used to it.

The U.S. currency's fate is tied to market speculators, geopolitics
and economic-trade crosswinds and will remain weak for both the short-
term and mid-term, unless major governments take unusual steps to
intervene.

“There's been a very dominant trend since 2001,” says economist Chris
Rupkey of Bank of Tokyo-Mitsubishi. “The foreign exchange market often
deals with themes and it sometimes difficult to change those.”

And those themes, or trends, often remain in place for years. Since
2000, for instance, the dollar has slid from a record high against the
Euro to a record low.

Though the U.S. currency is now very weak by historical standards, it
has been this weak before. On a trade-weighted, inflation-adjusted
basis, the dollar was actually weaker at two points in the 1970s, once
in the 1990s and as recently as the first quarter of 2008. Of course,
it was much stronger for much of the early 1980s, when it hit a record
high. (see chart below)

“The charts suggest this is the new reality for awhile," says Robert
Brusca, chief economist at FAO Economics. “Clearly, the dollar has to
be weaker. That's rational."

Most economists are unwilling to declare that this is, in effect, a
new dollar—weaker, of little stature and at immediate risk of losing
its status as the world's reserve currency. At the same time, the
greenback is unlikely to make a roaring comeback, as it did in the mid
1990s, the last time the doom-and-gloom quotient was high and market
and political analysts galore were bemoaning the debilitating drag of
the twin deficits (trade and budget).

At that time, then-Treasury Secretary Robert Rubin essentially
launched the we-want-a-strong dollar mantra, which though very
effective at first, has since become empty political rhetoric.

That’s where the national pride comes in. The world’s only superpower
(for now) should have a powerful currency, reflecting its economic and
military might. The difference this time is that a new economic-
military superpower with a huge trade surplus is emerging: China.

Given all this, it may be difficult, if not impossible, to achieve a
strong dollar again. Nor will it become some sort of Banana Republic
peso, even with the federal borrowing binges of the Bush and Obama
administrations.

“I don’t think there’s a new norm, or era, dollar,” says Rupkey.

Interest Rates: Changing Dynamic

Conventional wisdom says that exchange rates are mostly a reflection
of interest rates. The higher the rate, the more attractive the
currency, as investors seek the best return on their investment. Many
of those dollars get used to buy Treasurys or other U.S. assets.

Right now, not only are official U.S. rates at rock bottom, they are
about a full percentage point lower than those set by the European
Central Bank.

Though many expect the Federal Reserve to be among the first to raise
interest rates as the global recovery kicks, that is unlikely to
happen until late next year.

“This environment automatically allows leverage speculators to short
the dollar and buy gold short-term,” says veteran Fed and dollar
watcher David Jones of DMJ Advisors. “Then there’s the carry trader—
you borrow in low-interest dollars and invest in commodities
currencies, like the Australian Dollar and Brazilian Real, and that
makes the dollar even weaker. That will happen as long as Fed is
easy.”

What's more, the economies of both those countries have grown
enormously during the recent commodities boom, which has cushioned the
blow of the global recession. Australia, for instance, raised rates
months ago.

In the current post-crisis environment, there may be more than meets
the eye to the classic interest-rate dynamic.

Veteran Wall Streeter Ram Bhagavatula, now managing director at the
hedge fund Combinatorics Capital, recently analyzed the major
economies since 2008, looking at GDP, payrolls, productivity and
interest rates.

Next to Canada, the U.S. had the mildest recession. At the same time,
payrolls here were cut the most, while productivity surged.

"Which currency should be going up? It's the dollar, " says
Bhagavatula. "There's an issue with policy structure."

An analysis of central bank policy showed "the Fed stands out as the
central bank with the most explosive stimulation. This accommodation
was a substitution for rate cuts."

In other words, the accommodation is a proxy for interest rates and
the accommodation is much bigger than it appears.

"The policy of accommodation has outlived its usefulness," Bhagavatula
says.

Still, other economists say any interest rate differential in favor of
the U.S. may be both fleeting and modest.

Since it’s inception around the turn of the century, the ECB has erred
on the side of tight money and high rates, which happens to coincide
with the dollar’s slide.

What’s more, Japan has practiced a zero-to-low interest rate policy
for more than a decade and the dollar has never shown enormous
strength against the yen. Now, however, with rates about the same, the
dollar-yen exchange rate is about 80, barely higher than early 1995,
the time of the last dollar hysteria.

At best, favorable interest rate differentials may put a floor under
the dollar, but they are unlikely to make it strong.

Worries about a weak dollar’s role in the inflation equation have also
been overstated, say economists, even if it contributes to higher
commodities prices.

“The relationship between the dollar and U.S. inflation is very
diminished,” says Brusca, who notes that inflation failed to rage
during the weak dollar-string commodities boom of recent years.

Dallas Fed President Richard Fisher underscored that point recently,
saying, “Unless it becomes disorderly, a depreciating dollar—a
gradually depreciating dollar—doesn't necessarily add an enormous
inflation impulse.”

Trade Flows: More Powerful

Exchange rates may be more a function of global trade than anything
else and that goes well beyond the simple notion that the U.S. has a
bulging trade deficit.

"It's not just interest rates anymore," says Frank Vargo, vice
president for international economic affairs at the National
Association of Manufacturers. "Trade flows are very important and
lately the markets give more weight to trade."

For years now, most of the world’s largest economies and America’s
major trading partners—Germany, Japan, France, South Korea, Brazil—
have pursued economic policies emphasizing exports, which are
facilitated by weak currencies. The U.S. has been a stark exception.

Conversely, domestic demand in countries like Germany and Japan has
been relatively weak, but strong in the U.S.

“Everything is export driven,” observes Jones.

"There's got to be more domestic-led growth in these countries," says
Vargo. "That's what the G20 has been talking about."

In the 1980s, Japan’s booming, export-driven economy and undervalued
dollar was a problem for the U.S. The Plaza Accord of 1985 addressed
that issue with an agreement to devalue the dollar. (In a two-year
period, it lost about 50 percent of its value.)

“How do trade imbalances get changed over time?” asks Rupkey. "Witness
the Plaza Accord. A country gains a trade advantage and then the free
market creates a correction in currencies. You make the currency
appreciate and in doing so then make it too costly to export.”

Of course, that can’t happen with China, which has replaced Japan as
the new world trade Goliath, because its currency, the yuan,
essentially has a fixed rate, even though it is loosely pegged to a
basket of currencies.

“One of the biggest things that stands out in this crisis is that one
of our biggest trading partners is not seeing its currency
appreciate,” says Rupkey.

At the same time, China is not immune is hardly to the consumption-
import-export–growth dynamic.

Jones points out that the U.S. trade deficit fell from a peak rate of
6 percent of GDP in 2007 to about 2 ¼ percent in the second quarter of
this year, during the depth of the recession, which followed six
quarters of contraction in consumer spending. (Since then, the
percentage has been moving up as the economy improves). During roughly
the same period, trade shrunk from 10 percent of China’s GDP to 6
percent.

“If the trade deficit stays his low is China going to continue to
accumulate dollars?” asks Jones.

“Free market forces really need to change here,” says Rupkey. "The
burden is really more on the Chinese side.”

A stronger yuan/weaker dollar situation would certainly affect the
trade balance, but it won’t affect China's domestic policy.

“It’s not an easy adjustment to get the Chinese to increase domestic
demand." says Jones.

U.S. Borrows, China Lends

The U.S.-China trade dynamic has become all the more complicated at a
time of soaring Washington borrowing, creating a revolving door of
dollars, which may even put further pressure on the U.S. currency.

The U.S. buys cheap Chinese exports with dollars and China uses those
dollars to buy billions of dollars of cheap Treasurys, essentially
facilitating more U.S. borrowing.

This has been going on since the presidency of George W. Bush, when
the deficit-to-GDP ratio matched Reagan-era levels of 6 percent. Given
the financial crisis and the Bush and Obama administration policy
responses, that ratio is now about 10 percent.

There were howls during the Reagan years, but there were two key
differences then: the strength of the dollar and the identity of the
Treasury buyers.

“It’s a much more unstable and dangerous world,“ says Jim Rickards,
senior managing director at Market Intelligence “The single biggest
difference is that in the 80s our creditors were Japan, Europe and the
Arabs. All were utterly dependent on us for their security; our
national security was their national security. [China doesn’t] depend
on us for national security. We don’t have the lever to keep them in
line economically, in effect force them to buy Treasury securities.”

The symbiotic relationship between the U.S. and China and its impact
on trade flows, investment and exchange rates should be of greater
interest to the other key players in the global economy.

Economist after economist called it unsustainable.

The twin deficits, say economists, are something that makes people
want to sell the dollar, weakening it further.

Policy Vs Politics

Over the years prior to the single European currency, German
exporters, for instance, howled when the dollar was too weak against
the Deutsche Mark; their tolerance level with the Euro/dollar rate is
now thought to be 1.55, which is not far from the pre-crisis level of
2008. At roughly 1.48, now the dollar is down about 25 cents since
March.

American business, however, isn't complaining, especially. S&P 500
companies derive almost half of their sales overseas. Mid-sized
exporters are also benefiting.

"The dollar is definitely competitive now and we are seeing our
exports beginning to pick up," says Vargo.

And though trade may not be the job engine the housing and financial
sectors were in recent years, it is certainly producing jobs—and at a
time when the economy is losing more jobs than it creates every month
and the unemployment rate is in an uptrend.

Those most worried about the dollar policy think the Obama
administration and/or the Fed can and should do something about it.
Currency market intervention, however, has been rare and limited in
the past decade.

Bernanke surprised the markets recently by addressing the weak dollar,
which seemed to put a floor under the currency—at a level not too
different than when the central bank boss last addressed the subject
in June 2008, as crude oil was pushing $200 a barrel.

“As long as the decline is orderly, the Fed thinks it is a necessary
part of the global readjustment,” says Mickey Levy, chief economist at
Bank of America.

For now, words not deeds will probably suffice for policymakers.
What's to lose other than a little more value?

Economists say speculation about the dollar losing its place as the
world's reserve currency is is wildly premature.

For one, "there is no alternative," says Brusca.

In addition, reserve-currency changes are multi-decade events, as when
the dollar replaced the British pound after WWII, when its economic
and military superiority were entrenched.

Such a shift would probably also require major political developments,
such as the creation of a European republic—well beyond the current
economic and monetary union—or a democratic China with a free floating
yuan.

Economists say there should be more pressure on Beijing than the U.S.
to do something.

"The dollar over the next year or two will tend to see downward
pressure because our recovery will be fragile and uneven, and
consumers will spend less than they usually do," says Jones. "That's
why this adjustment is going to be so be so brutal.”

© 2009 CNBC.com