The Long View: Crumpled dollar bills

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Dollar weakness is not new. In January 2005, Saturday Night Live, the US comedy show, featured a sketch called “The Not So Incredible Adventures of the Down-and-Out Dollar”. One actress, dressed up as a dollar bill, had to suffer the jeers of fellow comedians dressed as a euro, a pound and even – with great glee – a Mexican peso.

Americans, unlike the British, are not normally so sensitive to the strength of their currency. The fact that it became the butt of jokes on late-night television showed how much the dollar had fallen.

After that, the dollar staged a muted recovery but, in the past few months, it has fallen once more, crossing $2 to the pound, hitting levels that had not been seen in 26 years and touching a record low against the euro. Against a trade-weighted average of other major currencies, set at 100 in 1973, the dollar this week hit a low of 78.91, meaning its value had slipped 21 per cent in that time. Why? And where will the dollar go from here?

In the very long run, exchange rates move to preserve purchasing power parity. In other words, at $2 to the pound, a product that costs $2 in the US should cost £1 in Britain. This implies that exchange rates should move in line with differences in inflation. If US inflation runs faster than that in Europe, the dollar must depreciate.

It is obvious to any international traveller that the dollar is trading well below parity. Since it peaked against the euro in October 2000, US inflation has been 18 per cent while eurozone inflation has been 14.7 per cent. That justifies a depreciation of 3 per cent or 4 per cent, not the 39 per cent depreciation that has in fact occurred.

Other long-term factors mean that purchasing power parity will not always be maintained. Most important is the current account balance. Alan Ruskin, currency strategist at RBS Greenwich Capital, points out that countries with large current account deficits tend to be weak relative to purchasing power parity.

That is the case for the US, which has been on a binge of buying imports. Classical theory says this should even out. The exchange rate should act as a balancing mechanism, making imports more expensive for Americans until a new equilibrium is reached. But now we have to take into account the market.

Investors choosing where to park their money care about interest rates. If dollar interest rates are lower than in Europe, it makes sense to move funds to Europe, causing the euro to rise and the dollar to fall. The first bout of dollar weakness in this decade came as the Federal Reserve aggressively slashed rates to combat what it thought was a risk of deflation.

After the Fed tightened monetary policy again, the dollar recovered. Renewed weakness has come as the Fed has been on “pause” at 5.25 per cent while the European Central Bank and the Bank of England have had to get more aggressive. Barring a big surprise, next week’s central bank meetings will leave the UK with a higher lending rate than the US, while the ECB will signal that its rates will rise further.

The cyclical factor of interest rate differentials must play out alongside the secular factor of the US current account. If the decline is primarily cyclical, as Marc Chandler, foreign exchange strategist at Brown Brothers & Harriman suggests, then, once the dollar hits a trough, it can recover – particularly if the US economy proves more robust than the market’s bearish expectations for it.

Then come shortest-term factors. Foreign exchange is not for the nervous. Unlike bonds or stocks, it is a zero-sum game. For every trade, the loser loses as much as the winner gains. In the short-term, foreign exchange is a trading game.

Traders look at the direction and momentum of exchange rates and try to capitalise. Hence strategists such as Chandler are suggesting that the dollar has further to fall – maybe to £2.06 or to €2.40 before a psychological low is formed.

Other actors are important. A weak dollar changes investor perceptions of other markets. The flood of US investors’ money into overseas mutual funds over the past two years owes much to the falling dollar.

The S&P 500 this week regained the 1,500 level it last reached in September 2000. Since then, while the US market was flat, the FTSE index for the world excluding the US has risen 53 per cent in dollar terms. But in local currency terms, it has grown by only 19 per cent. For UK investors saddled with the strong pound, the world outside the US has grown only 9.7 per cent. All of this encourages investors to avoid the US and weakens the dollar.

Then there are central banks. China, Russia and India have received huge inflows of reserves in recent months and have sold dollars to remain diversified.

So what can bring the dollar higher? Mansoor Mohi-Uddin, forex strategist at UBS, suggests that central banks will have to stop selling dollars, while a rise in the perception of risk must scare investors into directing investment flows back into the US.

In the longer term, the US economy must grow more than the market expects. Easier said than done.

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