Dollar Down!

Think the greenback looks weak now? It'll head even lower, although a dollar crash isn't in the cards.

By Andrew C. Schneider, Associate Editor, The Kiplinger Letter

October 3, 2007

What's ahead for the drooping dollar? More of the same, with periodic rallies to provide breaks in a long, slow slide.

The sluggish economy will take a toll until at least the middle of 2008. With U.S. growth slowing more dramatically than in most other countries, currency traders will place more bets on euros, British pounds, Canadian dollars and other currencies. Lower U.S. interest rates will also work against the buck. Other countries' central banks aren't following the Federal Reserve's lead in cutting rates. That means more investors who seek short-term gains in money and currency markets will opt to move funds outside of the U.S.

The dollar will perk up a bit in the second half of 2008, when the U.S. economy shows more bounce. But the currency won't be in the clear at that point. Fundamental global changes at work are eroding the greenback’s historical role as the standard-bearer for most of the world.

Other countries will hold fewer foreign reserves in dollar assets, thereby removing some of the demand for the U.S. currency over the longer term. Overseas governments with foreign-currency surpluses are increasingly looking beyond the safe harbor of dollar-denominated U.S. Treasuries to other investment opportunities with more profit potential. China, for example, has more than $1 trillion in official reserves, much of which is destined for new "sovereign wealth funds." While some of China’s money will probably end up in Treasuries and in stocks or bonds issued by U.S. companies, a lot will also be sunk into oil and mineral wealth in Africa, the Middle East, Central Asia and Latin America. Some will also be used at home to invest in financial and other infrastructure.

Meanwhile, the euro is becoming a keen competitor to the buck. Confidence in the euro flagged in the first few years of existence after its introduction in the beginning of 1999. Now, the euro is solid and the dollar is no longer the only game in town. Notably, euro-zone stock, bond and credit markets are doing battle with their dollar counterparts. And don't be surprised if foreign sellers of oil and other commodities -- items which traditionally have been priced in dollars -- decide in coming years to accept payments in euros as well.

Even so, we don't expect the dollar to collapse. The underlying dynamics of the U.S. economy and the diversity and depth of U.S. financial markets will always be magnet for funds from abroad and generate demand for greenbacks. The currency of a country making up about a quarter of the world's economy can't simply be written off. That said, we see little reason to expect strong rallies for the buck similar to the bull run that lasted from the late 1990s through 2002.

For the economy and some U.S. firms, the soft greenback brings benefits: More exports, for one. The hulking U.S. trade deficit is finally narrowing, if slowly, now that the weak greenback is helping to grow exports of aircraft, farm products and a host of other American-made items. Here at home, the currency situation lessens the threat of competition from imports for domestic companies that compete with them. For example, U.S. chemicals firms' sales here have risen at the expense of European and Japanese rivals. The same goes for domestic forest-products firms relative to their Canadian counterparts.

Another plus: U.S. companies book higher earnings from overseas units, since the foreign currency they earn is now worth more in dollar terms. Affiliate income from Europe, which accounts for more than half the income earned abroad by U.S. firms, was up 14% in the first six months of 2007 over the same period in 2006. The dollar's weakness will also lure in foreigners hunting for bargains on everything from vacations to corporate acquisitions. "Europeans are eagerly writing checks for Manhattan co-ops," says David Gilmore, a partner at Essex, Connecticut-based Foreign Exchange Analytics.

But pricier imports WILL hike companies' supply costs and fuel inflation, which is already being stoked by mounting wages. Moreover, after years of waiting for European and Asian consumers to increase their spending and help shrink the trade deficit, the U.S. is discovering there's a downside to shifting global consumption. "Because demand all over the rest of the world has picked up, the U.S. consumer is fighting against consumers all over the world for goods that are increasingly scarce," says Philip Suttle, director of global macroeconomic analysis at the Institute of International Finance. "Whether it's food or electronics, prices for consumer goods on the shelf are going to go up," he notes.

In addition, foreign investors will demand higher interest rates on the U.S. Treasuries they hold to offset currency-related losses. The upward pressure on interest rates forms this as well as from inflation will dampen economic growth -- another challenge to this expansion beyond the housing slump.

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