From a long-term perspective, the landscape for the embattled U.S. dollar appears bleak. The end of 2006 saw a short stretch of mildly optimistic economic data that provided the dollar with a decent bounce, but the move was short lived, and the overwhelmingly negative factors currently weighing against the dollar appear almost insurmountable for 2007 and beyond.
While there are multiple bearish factors facing the U.S. dollar, we can take some solace in a few comparative bright spots in the U.S. economic situation. These moderately optimistic dynamics may help to counter-balance negative forces and could possibly lend some support to the currency.
But before we even look at potential positives, let’s lay out the considerable bad news for the dollar.
To begin with, quarter-to-quarter annualized U.S. GDP growth experienced a marked decline in 2006, beginning at 5.6% in the first quarter, to 2.6% in the second and 2.0% in the third. For the last quarter of 2006, initial government data indicated a rather optimistic 3.5% growth rate. As it turned out, though, revised forth quarter figures revealed a considerably lower 2.2%, which was an unusually sizeable revision. You could argue that 2006 was characterized by declining and weaker-than-expected growth in the U.S. economy. And the Federal Open Market Committee’s (FOMC) forecast for real GDP growth in 2007 was cut to 2.5% from 3% to 3.25%.
By itself, this significant decline in GDP growth throughout last year might not have an earth-shattering impact on the dollar’s prospects. But currencies do not exist in vacuums, as value always is measured in relation to other currencies and economies. In this instance, the decline in the U.S. GDP growth rate takes on additional significance when the downtrend is set in stark contrast to other major global markets, most notably the Euro zone (see “Euro on the move,” below).
Economic growth for the Euro zone began in 2006 at 2.2%, but reached 2.7% by the end of the year. This represented the highest annual growth rate in six years, nearly doubling the 1.4% growth rate of 2005. It also represented the first time in four years that quarterly Euro zone growth surpassed U.S. growth. Granted, 2.7% is not the least bit impressive by U.S. standards. But the divergent direction of relative growth in the two economies, not the absolute statistical data, is the real key that can potentially have a significant negative impact on the dollar (see “Bad trend,” below).
CENTRAL BANK POLICY
Intertwined with economic growth, central bank policy also will play a major role in the dollar outlook for 2007. With Federal Reserve Chairman Ben Bernanke at the helm, the Fed paused its rate tightening campaign on Aug. 8, 2006, after 17 consecutive rate hikes beginning in June 2004. The strong expectation is that the Fed will refrain from changing rates at least until mid-2007. The near-future likelihood is that rates will be held steady, but there also exists a distinct possibility of easing by at least one-quarter point within the year.
Whereas we have experienced a relatively prolonged pause in the Fed’s tightening campaign, the perception is that the European Central Bank (ECB), and arguably the Bank of Japan (BOJ), are still well entrenched in their tightening cycles. The expectation is that the ECB will raise rates at least two more times this year, with the oft-quoted 4.0% as the goal.
As for the BOJ, it raised rates in July 2006 by one-quarter point after about six years under a zero interest rate policy, and raised rates again in February, bringing the benchmark to 0.50%. The indication from the BOJ was that any further tightening would be gradual.
You may read into this that the rate will probably be held steady: two hikes in seven months is a lot, considering the rate had been at zero for six years. The trend is definitely up. At 0.50%, it is not quite high enough to inspire a mass exodus from the short-yen carry trades that have helped contribute to a weak yen for so long. But if rates continue to rise, we should begin to witness a rather large-scale move away from the carry trade. This would strengthen the yen against the dollar.
The current and expected trends in global central bank rate differentials indicate a progressive decline in the U.S. interest rate advantage. Carry traders will have greater potential holding Australian or Canadian dollars as well as euros and pounds (see “Carried away,” below). This may likely prove to be a key factor in potential dollar depreciation for 2007.
Another key factor that threatens to weigh down the dollar is the staggering U.S. current account deficit. As economists have noted for years, a major proportion of this deficit has long been financed by foreign central banks. So essentially, the deleterious effects of escalating U.S. debt have been mitigated by the eagerness of foreigners to lend money to the U.S. Eventually, this suppression of the very serious underlying deficit problem is bound to exacerbate an already precarious situation.
Major foreign lenders include the central banks of China and other Asian countries and OPEC nations. As these lenders begin cutting back on their financing, or even just refrain from increasing their debt purchases, dollar depreciation will follow.
To cite one example of this phenomenon, reports came out earlier this year that OPEC nations were dumping U.S. Treasuries at a significantly accelerated pace. This was caused by falling crude oil prices since mid 2006. Major oil exporters sold around $10 billion, or almost 10%, of their U.S. government debt securities during the last three months of 2006. This kind of sell off may become the norm.
Besides these oil nations, other central banks around the world also are decreasing, or at least expressing their intention to decrease, U.S. dollar-denominated assets including both cash and government bonds. The most obvious example is that of China.
The multifaceted issue of China promises to have an enormous impact on economies and currencies across the globe. Perhaps no other single nation, besides the United
States itself, has a greater potential to affect the direction of the U.S. dollar than China. Unfortunately, all signs indicate this direction will be down. Whether this begins to manifest itself in 2007 or further into the future is the big question.
By now, we have all heard about China’s enormous reserve of foreign currencies and foreign government securities. As of this writing, the People’s Bank of China (PBOC) comfortably sits atop approximately $1.07 trillion in foreign-denominated assets. As the world’s top holder of foreign exchange reserves, China far eclipses Japan, Russia, India and every European nation.
Growth in China’s reserves also is staggering. Because of the country’s enormous trade surplus, reserves have been growing at a clip of almost $20 billion a month.
A majority of these reserves are denominated in U.S. dollars. Estimates range from 60% to 70% of assets currently held in dollars, with the rest in euros, yen and pounds. China is the second largest holder of U.S. debt, but China is curtailing its holdings. In 2006, China decreased U.S. debt purchases by almost 2%. It is no secret that China wishes to diversify its holdings to mitigate its enormous risk exposure to the U.S. dollar and to increase its investments in assets with higher returns. Unfortunately, any reserve diversification will invariably mean significantly fewer dollar-denominated investments, and that will lead to dollar depreciation.
Related to this is the progressive appreciation of China’s currency, the yuan. Of course, any appreciation in the Chinese currency contributes to dollar devaluation.
After having pegged the yuan at a fixed rate to the dollar for more than a decade, China relaxed the peg somewhat in July 2005 under unrelenting international pressure. Since then, however, China has retained a tight grip, allowing only relatively small movements in the exchange rate. A weak yuan is in China’s economic interest as it gives Chinese companies and exports a considerable advantage against those of other nations.
So artificially keeping the yuan weak has long been a priority for the Chinese government.
But with Henry Paulson heading the U.S. Treasury Department, the pressure on China to fully float the yuan may be getting stronger. Paulson has substantial China experience, a determination to make China the top priority and a resolute timetable for the yuan to float freely. This timetable includes widening the range that the yuan is permitted to move against the dollar. It also includes decreasing PBOC purchases of dollars, which China has already begun to do. If implemented, all of this will have a considerable depreciatory effect on the dollar.
THE GOOD NEWS
So after all of that bad news, what could possibly support the dollar in 2007 and beyond? For one, while the U.S. housing market has experienced tremendous declines, it appears this is not as correlated to declines in consumption. In other words, the housing slowdown unexpectedly is not affecting consumer spending or domestic demand to any great extent.
Previously, a positive correlation was held as virtually self-evident. So this can be considered a case of “not as bad as we expected” information, against the previous consensus that may help support the dollar.
Besides this, we also can look to the comparative structures of U.S. and European business to help support the dollar for the long term. As mentioned, the U.S. economy experienced a downtrend in its quarter-to-quarter growth figures in 2006, while the Euro zone made substantially positive strides. But if we view the absolute statistics, it can be argued that the U.S. economy may actually be hardwired for greater long-term growth than Europe. There are a number of arguments in support of this hypothesis.
Most important, the entrepreneurship and commercial innovation that are the hallmarks of U.S. business culture seem to be comparatively muted in Europe. Some would assert growth in Europe does not stem from innovation as it does in the United States, but instead from increased efficiency and productivity in predominantly existing industries. This essentially places a ceiling of sorts on future growth.
Also, it is much more difficult to hire and fire employees in Europe, so business is more prone to stagnation. European employees are not given nearly as much decision-making capability or free rein to innovate as their U.S. counterparts. In terms of European entrepreneurship, there are cultural, economic and regulatory hurdles to pursuing entrepreneurial activities. In short, the innovation that has fueled U.S. economic growth for so long is not as much of a force in Europe.
There also are other factors in the United States and global economies that may additionally lend a hand in propping up the dollar for the foreseeable future. But it remains doubtful that these positive forces can overcome the formidable circumstances weighing down the dollar in the long term.
James Chen is lead currency analyst for FX Solutions, a foreign exchange market-maker. He conducts forex trading seminars and writes frequent analytical reports on the currency markets. E-mail: firstname.lastname@example.org.