Outlook. for theus Dollar

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1 Outlook for theus Dollar The US dollar staged one of its most powerful rallies in August, with the 1 rising nearly 6% 2 that month. The breadth of the rally was also impressive, with the currency rising against a large number of currencies. The US dollar had been depreciating since 2002 and there are some who believe that this period of decline may have ended. However, the financial crisis which engulfed Wall Street in September has caused the rally of the US dollar to stall. The series of financial bailouts is adding to the debt of the United States government and this has raised concerns about the credit status of the US and by implication, the US dollar. 1 The was established in 1973 by the New York Board of Trade for tracking the value of the USD against a basket of currencies, which, at that time, represented the largest trading partners of the United States. It began with 17 currencies from 17 nations, but the launch of the euro subsumed 12 of these into just one, so the Index tracks only six currencies today. The Weights are Euro (57.6%), Japanese yen (13.6%), Pound sterling (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%) and Swiss franc (3.6%). 2 5

2 , 3 October Currencies are influenced by many factors but what was the main reason for the decline of the US dollar in recent years? Has this changed? The decline of the US dollar in recent years was fundamentally due to the growing trade deficit of the country. When a country runs a trade deficit, it is consuming more than it is producing. This is possible because it can borrow from the rest of the world. The current account deficit of the US as a percentage of GDP began worsening in 2002 and reached a low of 6.3% 3 at the end of Unless a country is completely closed to the rest of the world, most modern economies tend to run some degree of trade deficit or surplus, which typically fluctuates with the business cycle. Problems arise when a country begins to run a deficit or surplus which is out of sync with the business cycle. Financial markets are generally comfortable with economies that accumulate trade surpluses but ever growing deficits are seen as unsustainable. In the case of the US, the apparently inexorable rise of the trade deficit meant that there was an underlying pressure on the US dollar to depreciate. However, with the bursting of the US housing market bubble and the ensuing economic slowdown, US consumers have begun to cut back on their spending and the US trade deficit has narrowed. At the same time, the declining US dollar has made US exporters progressively more competitive while US exports have also been rising. As a result, the US current account deficit has been improving since 2006 although much of the improvement has been offset by a rise in oil prices as the US is a net oil importer. 3 6

3 US Dollar and US Current Account Deficit Mar-01 Jun-02 Sep-03 Dec-04 US Current Account Deficit Mar-06 Current account improving Jun Sep-08 Current account deficit as percentage of US GDP Current account deficit as percentage of US GD, 23 September Although the US trade deficit has been improving since the end of 2006, the US dollar, however, continued to decline. There was a particularly sharp fall in the US dollar following the eruption of the sub-prime crisis in August last year. Why was this so? The currency market is also strongly influenced by interest rates. As the sub-prime crisis emerged, the US Federal Reserve began to cut its key federal fund target rate, by a total of 3.25% 4 between September 2007 and March Cutting interest rates at this pace is considered extremely aggressive today. In contrast, the European Central Bank kept its policy rate unchanged for much of the period and even raised it by 25bps 5 in July The Euro/US dollar exchange rate is the mostwatched rate in the foreign exchange market. The trigger for the change in sentiment towards the US dollar was the realisation that the outlook for the rest of the global economy had deteriorated under the pressure of high oil prices and the ongoing credit crunch, and it appeared increasingly likely that other central banks would also have to follow the Fed in lowering interest rates. 3. The series of bailouts announced by the US authorities following the unfortunate events on Wall Street in September means that the debt of the US government will rise. What does this mean for the US dollar? The first large bailout announced in early September was the nationalisation of the Government-Sponsored Mortgage Enterprises (GSEs), Freddie Mac and Fannie Mae. The takeover of the GSEs did not have any apparent impact on the US dollar as the mortgage debt of the GSEs comes with an income stream i.e. the mortgage payments. Furthermore, the average GSE mortgage rate is higher than the US 10-year Treasury bills. Although defaults in Freddie and Fannie s loan books have been rising, the GSEs lend to the conforming not sub-prime loan market and the default rate is nowhere near the high levels being seen in the sub-prime market. Within a week of the GSE rescue however, the US Federal Reserve announced the bailout of American International Group (AIG). Although the US$85 billion 6 loan extended to AIG comes with punitive lending rates, the market s attitude towards the US dollar began to shift. The mood worsened as panic swept Wall Street in the week of 15th September with events culminating with the announcement by the US Treasury that it was seeking to buy illiquid assets from banks balance sheets. Unlike the GSE rescue, the US Treasury s bailout plan for troubled assets includes taking over a significant amount of nonperforming assets. The final cost to the taxpayer is, however, unlikely to amount to US$700bn as some of these assets are likely to have a recovery value. Furthermore, the rescue could help prevent the US economy from entering a deeper, more protracted downturn. This will help the government s fiscal position given that the taxes collected by the US government is highly sensitive to GDP growth i.e. the better the growth, the more tax revenue the government collects. All these are, however, longer-term considerations and in the short term, the currency market is likely to focus on the large initial financial layout proposed by the US government and this could weigh on the US dollar Source: US Federal Reserve 7

4 4. Asian currencies came under pressure when inflation spiked in the first half of Inflation appears to have peaked in a number of Asian economies but their currencies have not fully recovered. Why is this so? One reason Asian currencies continue to remain weak is the relative strength of the US dollar. In addition, Asian and all Emerging Market currencies have been affected by global risk appetite. The sharp deterioration in the outlook for the global economy has led to investors pulling out of Asian equities and bonds and these portfolio outflows have placed downward pressure on Asian currencies. With inflation on the decline in Asia, it is likely that Asian policymakers will engage in competitive devaluation, i.e. Asian currencies will be allowed to depreciate making exports more competitive as global growth weakens. Although the US dollar could strengthen again over the medium term, Asian currencies are, nonetheless, still likely to appreciate in value once the cyclical downturn is over. Structurally, Asia s large current account surpluses indicate that Asian currencies are undervalued Apr-95 Oct-96 Apr-98 Oct-99 Apr-01 Oct-02 Apr-04 Oct-05 Apr-07 Oct-08, 3 October

5 5. There is a close correlation between the US dollar and commodity prices. What is the outlook for commodity prices given the uncertain direction of the US dollar? The correlation between the US dollar and commodity prices is because commodities are priced in US dollars and a weak US dollar causes the demand for commodities to rise because the rest of the global economy can afford to buy more commodities. The impact is usually magnified because a large number of commodities are traded on financial markets and speculators can push prices to levels that are unwarranted by economic fundamentals. Similarly, prices can overshoot on the downside as well on the upside. Over the longer term, commodity prices are driven by real, physical demand and this is the underlying reason for the rise in commodity prices in recent years. Demand has risen because of the urbanisation of emerging economies such as China and India, which can be expected to continue over the next years. Prices have risen for commodities that are not traded by the speculative market, for example iron ore and coal. This means that commodity prices, particularly those where supply is tight, are likely to stay supported. 6. Finally, what about gold? Gold is strongly correlated with the US dollar although it also has a number of other unique characteristics. What is likely to influence the price of gold in the coming months? What makes gold different from other commodities is its safe haven status. Gold is sought most of all in times of war. The recent turmoil in financial markets has also led to a renewed focus on gold. The unprecedented developments in markets have raised anxiety in investors over a number of issues, including the US dollar. Any loss of confidence in the US dollar is likely to result in an increased demand for gold. and Gold (Reversed) US 82Dollar Index May-07 Jan-08 Gold Oct-08 Gold USD/oz Gold USD/oz Gold Price (RHS) DXY Index Reversed (LHS), 3 October

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