By GRAHAM FROST 22/08/2008
According to IMF estimates, the dollar’s real effective exchange rate fell 34% between February 2002 and May 2008. Due to low real interest rates and a ballooning trade deficit, the world has been happy to continue selling dollars, largely by borrowing or using dollars to invest elsewhere. Since March the dollar has been appreciating against major currencies and in August jumped up through the 200 day moving average favoured by traders. This was despite unfriendly data: a poor growth outlook, rising unemployment, a deteriorating housing market, a weak financial system, and higher energy costs. Is this the end of the dollar’s bear market?
Dollar bear markets tend to last 5 to 7 years, so the timing looks right although it can take a further few years to establish a bottom. Against other developed market currencies, it seems cheap. The US Fed seems unlikely to cut interest rates further, unlike the UK and Europe who are only waiting for inflation to subside. Japan is probably entering recession already. So the US is ahead of the game in terms of economic deterioration and policy response and hence may be first to recover. On the other hand, the dollar is overvalued against its trading partners in the emerging markets and its current account deficit is still at 5% of GDP. Although export volume growth is faster than import volume growth, surging dollar prices of imported materials and goods have offset the benefit. The US needs commodity prices to fall, especially oil, and for major developing trade partners to allow their currencies to appreciate. That would allow it to increase exports to those markets. But it can only do that if they are still growing, and if they grow too fast they consume more energy and more materials and push up prices. Overheating in emerging markets is already pushing up inflation and interest rates and there are signs that policy makers there are allowing some currency appreciation and pegs are beginning to wobble.
Even if one could predict all the above there is the issue of China’s $1.8tn exchange reserves. Will it speed up diversification out of the dollar in favour of other currencies?
Our view is that even if you can catch the bottom, it can take some years for a new trend to establish itself. Rather consider currency as an important diversifier to your home currency. When your home currency is sterling and suffers all the same problems as the US - weak housing, weak consumers, big trade deficit, weak fiscals, over exposure to financial services, and only at the start of the down cycle - it’s not hard to make a case in favour of the dollar!