Which Direction for the US Dollar? (G022)

Which Direction for the US Dollar? (G022)

Many analysts, politicians and investors are quite rightly asking which direction is the USA Dollar heading and is it sustainable? Since the second half of last year, the direction is unequivocally up.

In mid-July the dollar stood at a little over $1.60 against the Euro, but with the exception of one or two small set backs has risen since to the current level of $1.38

Last years weakness in the USA dollar may be attributed to a number of factors:
the widespread belief that the USA economy would move headlong into recession as a result of the sub prime mortgage crisis; the financial system would be hit particularly harder than those of other countries because of this crisis; and the Federal Reserve’s rather aggressive monetary policy response may result in systemic deterioration of the currency.

Despite these fears, the underlying USA economy has proven relatively robust compared to its overseas counterparts. In the second quarter, the economies of both Japan and the Euro zone contracted, with the UK remaining stagnant. US growth in the same period saw a rise of 3.3%.

Banks throughout both Europe and the Globe have seen a number of banking failures; nationalisations and mergers occur. The latest movements in the UK being the nationalisation of Northern Rock, the acquiring of Bradford and Bingley assets by Santander and the nearly completed acquisition of HBOS by Lloyds TSB.

The dollar has also been supported by the Federal Reserve Bank acting in such a way to prevent systemic risk - it allowed both Lehman Brothers to go ‘bust’ and Fannie Mae and Freddie Mac to be saved at the same time . Thereby providing confidence that both free market principles plus Central Bank intervention was, and is, possible.Naturally, there is the fear that the dollar’s relative strength may affect the US export competitiveness and weaker demand from Europe and Japan will take its toll.

However, there is some relief from emerging market economies which currently account for over half of US exports.

Michael Woolfolk, senior currency strategist at the Bank of New York Mellon is quoted as saying that the dollar is benefitting not only from weakening growth expectations at home, but also “While the United States has won the battle of the growth expectations for now, opinions in the market are deeply divided over the way in which Central Banks will respond to the continued rise in inflationary pressures”.
“If the US ends up winning the battle of the interest rate differentials, with the Federal Reserve lifting rates sooner than expected, the greenback has far more upside potential than many expect”.

Whilst third quarter growth in the US is likely to drop significantly, it must be borne in mind that a weaker economy is already choking back import demand and this trade deficit impact may prove supportive of the dollar. However, in order to sustain dollar strength the US needs to consume less and emerging markets such as China need to consume more – both of which are occurring.

In addition, the result of earlier dollar weakness has seen the growth in foreign direct investment (FDI) in the US. So a relatively cheaper dollar, gains in productivity and lower labour costs have enabled FDI in the US to rise by nearly two thirds last year to $277 billion. However, whilst FDI inflows would support the dollar, the latest budget forecasts from the US Council of Economic Advisers (CEA) which projects a record high deficit of $482 billion in fiscal 2009 may have an opposing effect.

Higher US interest rates may be required to maintain foreign inflows but if both budget and current account deficits surge and US interest rates remain at current level (or fall further) this would have a profound negative impact for the dollar.

Bearing in mind the current fear of a recession occurring it would be difficult to see the Federal Reserve even contemplating a rise in interest rates for some time yet.

The question as to whether the dollar’s rise is sustainable is difficult to predict at this stage. Too many negative variables may prove destabilising, but the Fed’s action preventing systemic risk as the result of the sub prime market; increasing foreign investment into the US and a relatively robust economy compared with Europe and Japan may enable a slow but gradual strengthening of the dollar to continue.

From an Associate's Blog

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