U.S. & Global Economies

Stronger Dollar Here to Stay

It’s the dollar by default -- a fact that will hurt the U.S. economy.

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

June 1, 2010

Expect the dollar to keep rising worldwide. It’s a second round of the flight to quality. As in late 2008-early 2009, investors are moving en masse to the safest assets available: U.S. bonds. While private demand has made up the bulk of recent transactions, that’s changing. Foreign governments have now joined the speculators in buying greenbacks, suggesting that a long-term trend is under way. Even Russia, one of the loudest critics of dollar reliance, is hedging its euro holdings. And Japan Post Bank is buying dollar bonds for the first time since 2006.

For the U.S., a rising buck is a net negative. It will widen the trade deficit and cost jobs in industries that depend on selling goods overseas. By early 2011, U.S. exports will begin to suffer in any markets where U.S. and European firms compete head-to-head.

Chemical manufacturers will be among the hardest hit. The weaker euro will give firms such as Germany’s BASF and Bayer and the United Kingdom’s INEOS an edge over Dow and DuPont. A similar disadvantage will hold for construction, mining and farm equipment firms, such as Caterpillar and John Deere. American exports of cars, paper goods, plastics, pharmaceuticals and medical equipment will likewise suffer. And just as the euro’s rise proved a boon for tourism, with Europeans flocking to New York for shopping sprees and Florida for cheap vacations, its plunge will keep many foreigners at home.

On the plus side, commodity prices will take a hit. Oil will likely slip to the mid-$60s by this summer, from about $75 a barrel now, before firming up a bit by early fall. Prices for most industrial metals -- aluminum, copper, zinc, nickel, lead, tin -- will slide 10%-20% by September. That will hold down manufacturing costs as well as inflation and long-term interest rates. But it’ll also help to hide underlying economic weaknesses in the U.S., letting policymakers and the public postpone tough decisions that need to be made.

The euro zone’s economic woes represent the primary reason for the stronger dollar. Greek debt turmoil and Europe’s fitful efforts to contain it have badly damaged global confidence in the euro as an alternative reserve currency. It’s the dollar by default, and not a sign of confidence in the U.S. economy.

“It’s like a beauty contest. You have to pick a winner, even if you don’t like the looks of any of the candidates,” says Barry Eichengreen, a professor of economics and political science at the University of California at Berkeley. “If you conclude the euro is singularly unattractive and the dollar is somewhat unattractive, who are you going to pick?”

The euro is now at its weakest level in four years, having fallen about 20% just since December, and it will continue to drop. But the effect is hardly limited to the euro -- virtually all other currencies are taking a beating. Europe’s economic woes are dragging the Swiss franc and Swedish krona lower as well. The British pound is taking a double dose, thanks to the U.K.’s own bleak fiscal outlook. The Canadian, Australian and New Zealand dollars are down because of falling commodity prices. The same holds true for emerging market currencies: the Mexican and Chilean pesos, the Indian rupee, the Brazilian real, the Russian ruble and the South African rand, among others.

The Japanese yen and Chinese yuan are two notable exceptions, but special circumstances apply in those cases. Investors had been borrowing yen at low interest rates to buy riskier assets elsewhere with potentially higher returns, a process known as the carry trade. They’re now unwinding those positions, sending money back into the Japanese economy and driving up the yen’s value against the greenback. The yuan, by contrast, is effectively pegged at a rate of 6.83 to the dollar and is appreciating against the euro in tandem. That’s bound to hurt Chinese sales to the euro zone, which now represents an even bigger market for Chinese exports than does the U.S. With that in mind, Beijing will be reluctant to lift its dollar peg soon and let the yuan rise higher still. That reluctance will aggravate trade tensions, raising the risk of a backlash in Congress.

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