Warning: A 15% drop in US dollar may be coming
The recent dollar rally on expectations that the U.S. Federal Reserve will begin to scale back its massive bond buying program later this year, is headed for a sharp reversal, says this economist.
Clifford Bennett, chief economist at Sydney based financial services firm the White Crane Group, said the dollar has been overbought and is due a correction of 15 percent over the next 18 months as the "dollar bubble bursts."
"This week saw the start of a potential major shift lower in the value of the U.S. dollar," he said.
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The prospect of the Fed tapering its $85 billion monthly quantitative easing (QE) program sent the U.S. dollar index, which measures the value of the dollar against the currencies of its major trading partners, to a three-year high early last week. However, the index fell sharply, by around 2 percent, in reaction to the minutes from the Fed's latest policy meeting released on July 10 that ruled out any immediate tapering plans. On Monday the index was at 82.92 in Asian afternoon trade.
"The moment that speculative buying begins to retreat, the U.S. dollar will, and most likely has already, begin a sustained period of decline. The U.S. dollar can be reasonably expected to decline some 15 percent over the next 18 months, if not sooner," he added.
According to Bennett, speculative money has been the key driver of large swings in the dollar's value. Many investors eagerly snapped up the currency in recent weeks on hopes that the end of QE in the U.S. would drive a rally. One of the objectives of such easing is to weaken a country's domestic currency and help aid a recovery, so the withdrawal of such stimulus normally leads to strength.
"While the U.S. dollar bulls are all excited about the end of quantitative easing as a reason to buy the greenback, working away in the background are a few other equally or more powerful bearish factors," said Bennett.
These factors include strong U.S. economic data leading to increased foreign investment by U.S. entities and global stabilization leading foreign holders to sell their Treasurys, both working to dampen dollar strength.
He added that the recent volatility over the Fed Chairman's comments masks a deeper fundamental reality, "it is crucial to understand that the reasons behind a strengthening U.S. economy, involve a weakening U.S. dollar."
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After contracting 3.5 percent in 2009 following the global financial crisis, the U.S. economy has shown signs of picking up in recent times, as job market and housing data have started to tick upwards. U.S. GDP grew 1.8 percent in the first quarter of this year, an improvement on a meager 0.4 percent in the final quarter of last year, and a soft greenback has aided the recovery making U.S. exports more attractive abroad and encouraging consumer confidence as well.
David Forrester, G-10 foreign exchange and fixed income strategist at Macquarie bank, said the U.S. economy does not need a weak dollar to aid its economic recovery.
"The U.S. economy is looking good, it is in recovery mode. It will not be a spectacular recovery, but it's approaching its potential," he said, adding that Macquarie forecasts GDP growth of 2 percent in 2013 and 2.5 percent in 2014.
"I don't think the dollar is in a bubble because U.S. economic growth looks relatively strong compared to Europe, the U.K. and Japan. If the U.S. economy was weak and the dollar was strong, then I could see the policymakers acting to weaken it. But we think the economic recovery there can handle a strong dollar," he added.
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—By CNBC's Katie Holliday: Follow her on Twitter @hollidaykatie