Bearish on the Dollar?
The recent flurry about the falling dollar has gotten me to look back in my old posts from the beginning of 2006. I do not know whether you can actually remember what we were talking about back in January but in that case let me refresh your memory through this piece in the FT by Martin Feldstein back in January in which the Harvard Professor notes that any substantial correction of the US trade deficit would entail a 30% drop in the dollar; see also New Economist for more sources.
Also The Economist also remarked on the dollar's perspective back in January. On this note it is of course important to precisely put things into perspective; the dollar has indeed been falling gradually in the last 4 years but at some point we must aks ourselves whether this correction process can go on? China is important here and the RMB's institutional de-facto dollar peg and continuing build up of reserves will of course become more and more unsustainable as we move along. However, this is also a highly automated development due to clout of the US and Chinese economies and their, after all, structural trade relationship. So what we basically have here is first and foremost a question of whether the dollar is heading towards a cliff and a free fall or whether the dollar will continue to decline more or less steadily?
This is of course where the big predicament is; even if the dollar continues it gradual decline it will not do much do correct the global imbalances because China and the petroexporters will most likely continue to hold the majority of their reserves on Treasury bonds. This leaves the Euro and the Yen as the major supporters of dollar depreciation and this is here I think all this talk about dollar meltdown runs into a serious problem. How do we expect the interest rate differentials to be in 2007? Back in January analysts came out of 2005 attributing the surprising strength of the dollar to the fact that the Fed held interest rates substantially higher than in Europe and Japan throughout 2005. The ECB was running the rate at about 2.25% and the BOJ was still at this point running its ZIRP. This has obviously changed now and the especially in the Eurozone the ECB has been raising rates throughout 2006 and with the US slowdown in the 3rd quarter this has of course increased the pressure on the dollar.
In the end, we are back to the fundamentals here in the sense that what we really need to talk about is whether we expect the ECB to be able keep raising (normalize the interest rate) and whether the BOJ in Japan can find the courage to muster a raise? My answer here is in both cases no and this is also why I ultimately do not expect interest rate differentials to narrow much in 2007.
However, interest differentials are of course only a part of this story and it is clear that as the imbalances continue to build up major holders of USD will be increasingly more exposed. Furthermore, the US current account deficit will also, all things equal, continue to push the dollar gradually down.
On a finishing note there has obviously been much flurry about this in the blogs and below I have included a couple of links. Of particular note is this piece by Brad Setser in which he touches upon all the issues described above and then some. However also Felix Salmon from RGE reports on how the Euro gains on the back of the slide in the dollar is beginning make politicians want to tell the ECB what to do? His message; Euro gains are no reason to meddle with the ECB. Also Menzie Chinn from Econbrowser chimes in by relating the concept of investor myopia to conundrum of why investors are willing to hold dollars despite relative and falling returns.