The U.S. dollar opened strongly in 2006, advancing about one percent against the major currencies in the first quarter as traders and investors speculated about additional Fed tightening under new Federal Reserve Chairman Ben Bernanke. The widely anticipated Fed rate hikes in February and March encouraged additional dollar purchases. But into spring there was bullish dollar sentiment as rising interest rate expectations faded and dollar selling pressures escalated in late April trading. Although I am confident that the dollar will continue to trend downward in the latter half of 2006, the greenback admittedly has proven surprisingly resilient in recent years.
Bearish dollar sentiment prevailed early in 2005 but the greenback edged upward during the year, confounding critics who predicted a long-overdue dollar depreciation. Despite a record $805 billion current account deficit last year, which theoretically should have depressed the greenback, the dollar rose about 6.5 percent on a trade-weighted basis in 2005. And despite hemorrhaging red ink in the trade and current accounts, the greenback received solid support from strong foreign capital inflows during the past 15 months as strong U.S. economic growth and rising U.S. interest rate levels led foreign investors to purchase dollar assets agressively.
End of U.S. Rate Hikes In December 2005 and January 2006, foreign capital inflows slowed sharply, which might have been signaling future investor reluctance to acquire additional dollar assets. The greenback encountered modest selling pressures in the April-May period as dealers contemplated the end of the Fed tightening cycle and speculated about a probable slowdown in the pace of economic expansion. Since Fed rate hikes and solid economic growth supported the dollar during the lengthy period from December 2004 to March 2006, I anticipate further dollar depreciation during the remainder of 2006 as foreign investors react negatively to stable U.S. interest rates and slackening economic growth.
Solid economic growth has traditionally provided a strong underpinning for a currency, so dollar strength during 2005 and the first quarter of 2006 is not surprising given the solid 3.5-percent U.S. gross domestic product (GDP) growth, which compared favorably with weaker growth in Europe and Japan. For the past several years, household consumption expenditures have provided major support for U.S. economic expansion; however, the pace of consumer spending seems likely to slow somewhat in the months ahead as higher interest rates dampen housing activity and households struggle to cope with rising debt service payments. The spike in the price of crude oil to $70 per barrel also erodes households’ purchasing power. The consensus economic forecast predicts a modest slowdown to three percent GDP growth this year. However, I expect annualized real economic growth to dip below three percent by year-end. Now, let’s take a look at the key factors for those trading in the FX arena.
Interest Rate Differentials Are Key New day traders often eagerly embrace technical analysis in formulating their currency trading strategies. But successful independent traders can’t afford to ignore the critical role global interest rate differentials play in influencing shifting currency values. In the 1970s and early 1980s, currency forecasters focused on foreign trade shipments to determine fluctuating exchange rate movements, but the integration of the world’s financial markets over the past 25 years has significantly enhanced the mobility and magnitude of global capital flows which swamp trade flows and primarily determine the relative values of currencies today. Rising U.S. interest rates enhanced the attractiveness of dollar assets during 2005 and early 2006, but this supportive dollar influence eased this spring, especially because there was speculation about upward pressures on interest rate levels in Europe and Japan.
Time For Some Homework Independent day traders often lack specialized knowledge about the intricacies of international trade and finance, but like profitable institutional traders, they must learn about the dampening influence chronic U.S. balance of payments problems exert upon the greenback. Since the 1980s the U.S. has registered deficits in trade with foreigners. That simply means U.S. citizens have bought more goods and services from foreigners than we have sold to them. Chronic U.S. trade deficits are the largest factor undermining dollar stability. When analyzing U.S. balance of payments problems, economists and dealers normally focus upon current account transactions.
The current account is the most comprehensive measurement of the trade performance of the U.S. It encompasses sales, purchases of physical goods and services, and investment income flows. Since the early 1980s the U.S. has recorded chronic current account deficits — meaning the U.S. has essentially been living beyond its means. U.S. citizens spend more on foreign goods and services than they earn from foreign commerce. In order to pay for these excessive purchases, the U.S. has relied upon foreign financing in the form of global investor purchases of U.S. securities. The current account deficits have widened dramatically in recent years, which means the U.S. has been flooding the world with dollars. Theoretically, this huge supply of dollars could depress the value of the greenback unless there are strong offsetting global demands for dollars.
Deteriorating U.S. trade accounts have not seriously undermined the greenback during the past twenty years because foreign investors, especially Asian central banks, have been willing to purchase large quantities of dollar assets, including U.S. Treasuries. The resulting inflows of capital have easily financed chronic trade deficits and propped up the dollar. During the 2000-2002 period, net annual inflows of foreign capital averaged $450 billion, but by 2004 these inflows spiked toward $700 billion, explaining the dollar’s strength last year.
Recent Market Action The dollar exhibited undertones of strength until April, but recent slippage suggests further weakness in the remainder of 2006 as the greenback loses the supportive influence of Fed rate increases. In April the dollar encountered selling pressures as investors and traders reacted negatively to a Fed report that implied an early end to the tightening cycle. Dollar sales intensified in early May following a G-7 (Group of Seven) recommendation that Asian nations sanction appreciation of their currencies to help shrink trade surpluses with the U.S. About 70 percent of central bank international reserves are held in dollars. However, several central banks recently indicated their intention to increase the percentage of euros in their reserve holdings.
Going Down By early May the dollar had slipped to a 12-month low against the euro ($1.2725) while easing to a seven-month low versus the yen, which traded near 112.50. A debate persisted in the financial markets about how high interest rates would go. As anticipated, on May 10 the Federal Open Market Committee (FOMC) hiked the Fed funds rate to a five-year high of five percent. Fed officials implied further rate hikes might be necessary to “address inflation risks,” although the FOMC also indicated that additional restraint would only be implemented if dictated by future economic conditions.
A summer Fed decision to push the funds rate to 5.25 percent or higher is certainly possible but not very probable. Inflationary pressures remain moderate and no surge in prices seems likely, especially if an expected moderation in economic growth materializes. I am personally convinced that the funds rate has peaked at five percent. Looking ahead, this could mean summer/fall dollar sales as dealers speculate about possible interest rate hikes by the European Central Bank (ECB). Recent inflation concerns in the United Kingdom suggest the Bank of England might also push interest rates upward this year.
The U.S. will likely register a record merchandise trade deficit in excess of $750 billion this year while the current account deficit widens to $950 billion – six percent of GDP. Monthly trade deficits of $75 billion will probably not be covered by capital inflows of comparable magnitude, which suggests U.S. dollar weakness could be ahead.
A Look Ahead To Year-End And Beyond Slackening U.S. economic growth and expectations of possible Fed easing in 2007 suggest the greenback will close the year softly, probably easing about ten percent on a trade-weighted basis for the year. In a weak dollar environment the euro will likely close 2006 near $1.32, retaining early year strength bolstered by improved European economic growth and rate hikes enacted by the ECB. Sustained Japanese economic growth of three percent should push the yen up to the 109 level. The yen should also derive support from a less-accommodative monetary posture by the Bank of Japan.
The outlook for the dollar in 2007 is obviously clouded by geopolitical developments in Iraq and Iran, but I anticipate additional dollar weakness early next year. The greenback will likely be undermined by slower sub-three percent economic growth, widening U.S. payment imbalances and probable Fed easing.
The longer-term outlook for the greenback also appears unfavorable since the vast majority of economists would agree that steadily widening U.S. trade deficits constitute an unsustainable condition that will eventually foster a major depreciation of the dollar. The latest World Economic Outlook published by the International Monetary Fund suggests “significant” dollar depreciation will be necessary in order to correct global payment imbalances, which threaten to undermine economic prosperity in the world economy.
Digging Deeper The 2006 Economic Report of the President contains a chapter discussing U.S. capital account surpluses, which are the counterbalance to U.S. current account deficits. The capital account is a major sub account of U.S. balance of payments statistics that primarily documents U.S. sales and purchases of financial assets. Countries like the U.S., which register chronic current account deficits, actually record capital account surpluses. Why? Excessive U.S. purchases of foreign goods and services are financed by foreign investor purchases of U.S. assets, which yield substantial foreign capital inflows. The chapter highlights several factors that explain why foreign capital inflows have recently escalated, including low domestic savings, rapid economic growth, sophisticated U.S. financial markets and the dominant role of the dollar in the global financial system. Since the U.S. has become critically dependent upon foreign financing, there naturally are questions about whether this reliance upon foreigners is sustainable.
Theoretically the U.S. could continue to receive large capital inflows indefinitely as long as the global financial community remains attracted to dollar-denominated securities, but economists on the President’s Council of Economic Advisers expect the magnitude of inflows to moderate in the future, since these inflows currently are at historically high levels, six percent of GDP.
The Ticking Time Bomb The timing of significant dollar weakness in the future remains highly uncertain and unpredictable. Few economists or currency experts are predicting an imminent dollar crisis given the recent foreign appetite for American securities. Nevertheless, modern investment portfolio theory advocates diversification, which suggests that eventually the enthusiasm of investors for dollar assets will wane and the dollar will slide downward. The esoteric subject of U.S. balance of payments problems receives little attention in the financial press; however, some economists warn escalating U.S. trade deficits constitute a ticking time bomb that will eventually destabilize the world’s financial markets.
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