Over the past few months, there seems to have been excessive but not unusual focus by market commentators and, to some extent, mainstream Wall Street strategists, about the dollar’s direction. In Lebanon, a highly dollarized economy, the issue has also been on the forefront as many Lebanese gauge their wealth in dollar terms. Those who have not diversified their liquid assets have seen their purchasing power halved vis-à-vis the euro, and the drop has been especially painful for importers of European goods.
This focus appears odd, since most of the large decline in the greenback started in early 2001 and has run nearly 40% against the euro (30% in Dollar Index terms). While the fundamental backdrop continues to be unkind to the dollar, there are some signs that in the immediate future, the drop may have reached a point of exhaustion of sorts. The overwhelming fiscal deterioration, the gradual erosion of federal re-flation attempts and ensuing poor maneuverability of monetary tools to the massive debt overhang, and the weak perception of US policy abroad are all well known fuel agents for the multi-decade bear market. And in some respect, a case can be made for the secular decline to continue well into the early part of the century, but for the near term, a different set of dynamics, more relevant for gauging trajectory at inflection points are telling a different story.
The short dollar trade from a technical perspective is crowded. The consensus is greatly leaning against the US currency, reaching only 4% of Bullish Sentiment according to Market Vane, and nearly all major media vehicles are writing the dollar’s epitaph. There is no real new dollar crisis, just a continuation of policies that do not favor the Treasury’s “strong dollar policy” dogma. But the acceptance of the dollar’s decline has become too widespread, and to some degree, this asymmetrical market situation will need to be corrected. With yield spreads converging on a 10 year note basis between the dollar and euro, there is room for the dollar to move up, in a countertrend fashion. Such moves can be brutal, especially since they mostly happen in a backdrop of continued “bad news.” The consensus view of how to solve the burgeoning US trade deficit gives the falling dollar a key roll. This view follows traditional economic theory, which supposes that a fall in the value of a nation’s currency, relative to the currencies of its trading partners, will eventually improve the trade balance of that nation. Alan Greenspan, the Chairman of the Federal Reserve, has made this argument. Early in 2004, he said: “The currency depreciation we have experienced of late should eventually help to contain our current account deficit as foreign producers export less to the United States.”
In the chain of reasoning behind this theory, the falling dollar presumably affects the trade balance in two different ways. First, as the value of the US dollar falls, the value of foreign currencies will rise; consequently the US dollar price of imports will also rise. Since, as a general economic principle, higher prices should reduce demand, the level of imports to the US should fall. And as demand for higher-priced imports falls, the US trade deficit will improve. Greenspan’s comment refers specifically to this effect. As a corollary of this, the higher price of imports will stimulate demand for equivalent goods that are produced domestically (so-called domestic substitution, such as buying US produced wine instead of imported wine).
Second, in the traditional theory, the lower dollar will also improve the US trade balance through the export side of the equation. Just as imports will become more expensive because of the lower value of the dollar, US exports will become less expensive in their foreign markets. And just as higher prices should curtail import demand, the lower dollar prices of US exports should stimulate demand for US made goods and services in foreign markets. In theory, through the intermediary of the lower dollar, the combination of higher prices for imports here and lower prices for US exports abroad will gradually bring down the huge trade deficit.
The US dollar has indeed fallen in value – for over two years now – but in reality how effective will this prove in improving the nation’s trade balance? Beginning in early 2002, the dollar had a value of about 117 (the US Dollar Index), measured against a group of major foreign currencies. It now stands at about 85, a decline of nearly 27%. Half of this decline has occurred since early this year, when Greenspan made the comment quoted above. A decline of this magnitude and over this length of time should certainly be sufficient to see whether the lower dollar has begun to have the desired effect of increasing US exports and decreasing imports.
To estimate the effectiveness of the lower dollar, we can compare the level of exports, imports, and the trade deficit in March 2002 with the most recent figures available when this was written. Over this time period, exports have increased 21% while imports have increased 35%. The monthly trade deficit itself has increased 70%, from $31.5 billion in March 2002 to $54 billion in August 2004. In other words, while the lower dollar may certainly have helped to increase exports, its effect on imports contradicts theoretical expectations, as they have grown even faster than exports. The result is a mushrooming trade deficit that expands even as the dollar falls. The situation not only runs counter to theoretical expectations, but to Greenspan’s expectations as well. One can only wonder what might be wrong with the theory.
When reality contradicts theory (whether in economics or another science), the source of the problem often lies in the assumptions that a theory makes about reality. In this case, traditional theory assumes that the value of our trading partners’ currencies float against the dollar. That is, the values of currencies are relative to each other: when the dollar falls in value, foreign currencies should increase in value relative to the dollar, and vice versa. But the real world is different. The value of some currencies does rise and fall against the dollar. However, the value of other currencies, notably those of some Asian countries, is either tied directly to the level of the dollar (a so-called hard peg) or tightly controlled relative to the dollar (a so-called soft peg).
For Lebanon, the collapse of the dollar has meant, along with lower rates, less pressure on the Lebanese Pound. Some pundits argue that had the dollar been too strong, some pressure on the local currency might have materialized. It is key here to remember that the low inflation/low interest rate environment in US has been a positive factor on monetary stability in Lebanon.
It is also relevant to note that in fundamental terms, the euro, Swiss et al, are not exactly safe havens when you consider the sticky unemployment and structural imbalance, not to mention immigration headaches. So while dollar bears, rightly, pound the table on poor US ingredients and misguided monetary chefs, a lot can also be said about European macroeconomic influences. Germany, the engine of Europe, is stalled in most statistical measures, and unemployment refuses to drop below 10%. The European central bank is caught in the straightjacket of inflation fighting and simply watches as the deflationary impact of a massive upward move in the euro hits home.
The blend of overdone technical factors and overly telegraphed risks make the dollar worth watching on the upside. Long term dollar based investors may want to look at decreasing their holdings in non dollar zones from a purely tactical perspective. The natural caveat to this scenario, which seems to point to a possible 15% up move in the dollar, is a sudden geopolitical event, or a negative systemic even in the US financial market, such as a large failure or a sharp dislocation in fixed income markets.
Here it is worth noting that the degree of complacency prevalent toward the euro (and most other major currencies) has an analog in the stock and junk bond market. The stock market euphoria goes unabated, still punch drunk from election fantasies, and junk bond spreads have narrowed to dangerous levels. It is possible for an asset market correction in the US to coincide with a dollar upswing, but only temporarily. If the secular bear in stocks returns with a vengeance, the dollar swoon would take on a new, more violent form.
In the meantime, a high degree of caution should be used when considering non dollar investments, as 2005 could be the year of the greenback bounce back. For the Lebanese trader, it seems some relief is on the way, and for investors, a chance to exit the dollar appears on the horizon in the year ahead.