Dollar's Fall Is Scary but Not a Reason to Panic

The dollar will go lower before rebounding, but rebound it will. The only question is -- when?

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

March 12, 2008

The dollar will continue to test new depths this year. It's likely to reach a new low point as a freely traded currency, beating its previous post-Bretton Woods nadir set in October 1978. Individual exchange rates will provide eye-catching markers along the way, with the euro climbing past $1.60 and the yen rising to its highest level against the dollar since 1995.

A combination of factors is continuing to drive investors away from the greenback. First and foremost is the steady drumbeat of bad news about the U.S. economy: the ongoing housing and credit crunches, poor auto sales, weak job growth. Each fresh signal that the U.S. might be entering a recession, or is already in one, prompts traders to seek healthier alternatives than greenbacks.

Increasingly, institutional investors are putting their money into oil, precious metals, iron ore, coffee and grain in search of higher returns. That's keeping prices high, and adding to inflationary pressures, even as slower global growth suggests demand for commodities should be moderating. "Historically, investors, particularly institutional investors, are reluctant to hold commodities because they don't pay interest," says Benn Steil, director of international economics at the Council on Foreign Relations. "Now you have investors saying, 'If I hold my wealth in dollars, I'm going to get a negative return. This is a really bad deal.'"

But the greenback won't collapse, and eventually it will rebound. The dominant position of large global investors in the foreign exchange markets, particularly central banks, acts as a significant bulwark against the panic selling that would signify a rout. Such large holders of dollars might want to diversify, but because the foreign exchange markets can handle only so many trades at one time, they can't afford to be seen as dumping their greenbacks. "If they sell even part of their holdings, the rest of their holdings would crater," says Mark Zandi, chief economist for Moody's Economy.com.

Several other factors weigh in favor of a dollar turnaround. One is that the dollar's persistent weakness will continue to make U.S. exports more competitive. At the same time, weaker U.S. growth will reduce demand for imports, accelerating the reduction in the trade deficit that began in 2007. The rapid growth of the trade deficit in recent years was one of the main reasons investors began turning away from the dollar in the first place.

It's also worth noting that the British pound and the Canadian dollar have both retreated against the greenback in recent months as the Bank of England and Bank of Canada cut interest rates to respond to economic slowdowns of their own. The European Central Bank (ECB), by contrast, retains a bias toward fighting inflation over promoting growth and remains extremely focused on the effects of high commodity prices. One major reason the euro has continued setting new record highs against the U.S. dollar is that the ECB has held rates neutral, even hinted at rate hikes, while the Federal Reserve trimmed rates.

Investor confidence in the dollar is a proxy for confidence in the U.S. economy as a whole, and the U.S.' economic problems, however worrisome, are cyclical rather than structural. As the U.S. starts to recover in the latter half of this year, investors will come trickling back. Meanwhile, growth in the euro zone itself will continue to slow. By year end, currency traders will start to take account of the relative strengths of the two economies, and the euro will start to retreat, leveling off close to $1.40.

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