Long-Term Dollar Prospects: New Reflections

February 3, 2009

Inspired by new measures unveiled in a number of countries to support growth and credit markets, foreign exchange markets grew more confident today that the banking crisis and recession will end eventually.  The dollar and yen have been major beneficiaries of risk aversion, so on days like today when investors see a glimmer of light at the end of the tunnel, those two monies tend to settle back in value against major European currencies and commodity-sensitive currencies.  Optimism about exiting the economic crisis has not been sustained thus far, which means that there have been more good days for the dollar and yen than bad ones.  It’s hard for investors to remain confident day in and day out when:

  • Too much uncertainty surrounds the impact of policy actions being taken, especially since many steps since the summer of 2007 that were thought sufficient when announced turned out to be inadequate.
  • The light at the end of the tunnel remains very far away.
  • Economic data continue to run very bleak.  Even better-than-expected statistics, such as manufacturing PMI’s, only convey that the rate of economic contraction didn’t continue to accelerate, but the direction is down.  And the speed of drop is very rapid.

Days like today serve as a reminder that present dollar resilience is transitory and based on fear, not strong economic fundamentals.  Presuming that a time will come when recovery takes hold, the dollar will become vulnerable to more sustained selling pressure.  Alternatively, if the recession continues much longer than hoped and ushers in a decade or so of limp activity like Japan’s L-shaped business cycle in the 1990’s, the dollar and yen are increasingly unlikely to levitate on the strength of capital flight.  The United States needs to rotate growth away from domestic demand and toward net exports.  We see this happening already in the climbing savings rate, which tripled from 1.2% in September to 3.6% just three months later.  There’s still a long way to go, however, to return to the 6-8% long-term trend for savings.

If the dollar is appreciating, net exports will not fill in the gap vacated by weaker domestic demand.  Even if markets are comfortable with this short-circuited correction, officials will not indefinitely tolerate a state of under-production. Policy changes to cap dollar strength would be taken.  As for Japan, that economy remains overly reliant on net foreign demand.  Economic performance in Japan would compare increasingly poorly with other regions if the yen climbs further or merely remains at present firm levels.  As Japan struggles singularly and not merely along with all other economies, a softer yen likely will unfold.

Copyright 2009 Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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