Which way are you going?
The US dollar has been falling against the euro since the end of October 2000, when one euro bought you 83 dollar cents. Since then the dollar has entered a period of strong depreciation which results in an exchange rate of 1,58 USD per euro today. Is de dollar near the end of the depreciation or can we expect a further fall of the greenback?


Let’s take a look at some fundamentals which play a role in the decline of the dollar.

One of the main reasons for the dollar decline can be found in globalization. For quite some years now we have been witness to the continuing integration of economies all over the world into one global economy, although many economic and political barriers still remain. This process has created enormous imbalances in the world: economies like China, India, Taiwan and South Korea, who have almost unlimited sources of cheap labour, have been the producers of goods, which were bought and consumed by developed economies like the US and Europe. The massive payments to the producing countries have created large capital reserves, which were invested in the US and Europe. Because of these large capital inflows yields in the US and Europe could remain artificially low, which in turn boosted economic growth and with that consumption, creating more demand and thus stimulating economic growth in production countries. This cycle has led to high economic growth and a large build up of foreign capital reserves in production countries and a build up of debt specifically in the US, with government and private consumers alike. Differently put the US were consuming cheap products produced in developing countries, led by China, with money lent from these same developing countries. The US government meanwhile has lowered taxes and has had to finance a very expensive war in Iraq, creating a double deficit and weakening the economic and financial position of the US. The dollar reacted by depreciating while the situation deteriorated.

More recent in nature is the declining economic growth in the US, where the credit crisis originated. Other economies were able to keep growing despite the problems in the US, which added to the weakening of the dollar. The Federal Reserve responded by lowering the short term interest rate, trying to support economic growth. Lower interest rates in the US mean that investment in US bonds is less attractive relative to higher yielding bonds in Europe, resulting in further downward pressure on the dollar.

So where do we go from now? The US economy is on the brink of entering recession territory, the US housing market is still declining and consumer spending is under pressure. However, despite rising inflation the Federal Reserve has lowered interest rates sufficiently to be a stimulus for the economy, which may prevent the US from entering a deep and prolonged recession. Meanwhile the credit crisis is starting to impact economic growth in other parts of the world. The European Central Bank, focusing solely on inflation where the Federal Reserve also considers itself a guardian of economic growth, recently raised interest rates. Declining growth worldwide means the difference in economic growth with the US will most likely decline as well, supporting the US dollar. Interest rate differentials may be close to their peak, with rates in the US already being low enough to effectively stimulate economic growth, and rates in Europe and the UK being still neutral to modestly restrictive. If the interest rate differential with the US declines, the dollar will most likely appreciate against the respective currencies. On a geopolitical scale the US looks to be gradually finding their way out of the Iraq-debacle, which will improve their capital and debt position. The economic problems of the US and the weak dollar are already cutting back consumer spending, which will help improve the trade balance deficit which in turn will support the US dollar.

Looking at the big picture the most likely road for the US dollar is a gradual appreciation. Credit Agricole analysts have calculated a fair value for euro/dollar of 1,15-1,20 based on Purchasing Power Parity and around 1,30 based on a more comprehensive econometric model. Although fair values are not stable over time as input variables (economic growth, productivity gaps etc) also change over time, and real exchange rates fluctuate substantially around fair values instead of move in line with them, calculating a fair value gives an idea of where the exchange rate should be headed in the near or more distant future. Risks for the above scenario are a deeper then expected recession in the US as a result of the credit and housing market crises and a further steep rise of oil and commodity prices. However, those of you who think that the age of the greenback is over, may well find that Uncle Sam isn’t really the misguided old man he appeared to be these last few years.

Rob van Wechem, CFA

Rob van Wechem works as an investment consultant for Oyens & Van Eeghen in Amsterdam. This article expresses his personal views on the financial markets and does not represent the views or opinions of Oyens & Van Eeghen