Why the US Dollar Will Likely Remain Weak for Some Time
The dollar is weak. Get used to it.
The U.S. currency's fate is tied to market speculators, geopolitics and economic-trade crosswinds and will remain weak for both the short-term and mid-term, unless major governments take unusual steps to intervene.
“There's been a very dominant trend since 2001,” says economist Chris Rupkey of Bank of Tokyo-Mitsubishi. “The foreign exchange market often deals with themes and it sometimes difficult to change those.”
And those themes, or trends, often remain in place for years. Since 2000, for instance, the dollar has slid from a record high against the Euro to a record low.
Though the U.S. currency is now very weak by historical standards, it has been this weak before. On a trade-weighted, inflation-adjusted basis, the dollar was actually weaker at two points in the 1970s, once in the 1990s and as recently as the first quarter of 2008. Of course, it was much stronger for much of the early 1980s, when it hit a record high. (see chart below)
“The charts suggest this is the new reality for awhile," says Robert Brusca, chief economist at FAO Economics. “Clearly, the dollar has to be weaker. That's rational."
Most economists are unwilling to declare that this is, in effect, a new dollar—weaker, of little stature and at immediate risk of losing its status as the world's reserve currency. At the same time, the greenback is unlikely to make a roaring comeback, as it did in the mid 1990s, the last time the doom-and-gloom quotient was high and market and political analysts galore were bemoaning the debilitating drag of the twin deficits (trade and budget).
At that time, then-Treasury Secretary Robert Rubin essentially launched the we-want-a-strong dollar mantra, which though very effective at first, has since become empty political rhetoric.
That’s where the national pride comes in. The world’s only superpower (for now) should have a powerful currency, reflecting its economic and military might. The difference this time is that a new economic-military superpower with a huge trade surplus is emerging: China.
Given all this, it may be difficult, if not impossible, to achieve a strong dollar again. Nor will it become some sort of Banana Republic peso, even with the federal borrowing binges of the Bush and Obama administrations.
“I don’t think there’s a new norm, or era, dollar,” says Rupkey.
Interest Rates: Changing Dynamic
Conventional wisdom says that exchange rates are mostly a reflection of interest rates. The higher the rate, the more attractive the currency, as investors seek the best return on their investment. Many of those dollars get used to buy Treasurys or other U.S. assets.
Right now, not only are official U.S. rates at rock bottom, they are about a full percentage point lower than those set by the European Central Bank.
Though many expect the Federal Reserve to be among the first to raise interest rates as the global recovery kicks, that is unlikely to happen until late next year.
“This environment automatically allows leverage speculators to short the dollar and buy gold short-term,” says veteran Fed and dollar watcher David Jones of DMJ Advisors. “Then there’s the carry trader—you borrow in low-interest dollars and invest in commodities currencies, like the Australian Dollar and Brazilian Real, and that makes the dollar even weaker. That will happen as long as Fed is easy.”
What's more, the economies of both those countries have grown enormously during the recent commodities boom, which has cushioned the blow of the global recession. Australia, for instance, raised rates months ago.
In the current post-crisis environment, there may be more than meets the eye to the classic interest-rate dynamic.
Veteran Wall Streeter Ram Bhagavatula, now managing director at the hedge fund Combinatorics Capital, recently analyzed the major economies since 2008, looking at GDP, payrolls, productivity and interest rates.
Next to Canada, the U.S. had the mildest recession. At the same time, payrolls here were cut the most, while productivity surged.
"Which currency should be going up? It's the dollar, " says Bhagavatula. "There's an issue with policy structure."
An analysis of central bank policy showed "the Fed stands out as the central bank with the most explosive stimulation. This accommodation was a substitution for rate cuts."
In other words, the accommodation is a proxy for interest rates and the accommodation is much bigger than it appears.
"The policy of accommodation has outlived its usefulness," Bhagavatula says.
Still, other economists say any interest rate differential in favor of the U.S. may be both fleeting and modest.
Since it’s inception around the turn of the century, the ECB has erred on the side of tight money and high rates, which happens to coincide with the dollar’s slide.
What’s more, Japan has practiced a zero-to-low interest rate policy for more than a decade and the dollar has never shown enormous strength against the yen. Now, however, with rates about the same, the dollar-yen exchange rate is about 80, barely higher than early 1995, the time of the last dollar hysteria.
Inflaton Not a Worry
At best, favorable interest rate differentials may put a floor under the dollar, but they are unlikely to make it strong.