Looks to Be a Down Quarter for the Dollar — What’s Next?

September 21, 2012

Just a single week remains of the third quarter of 2012, and the dollar is showing net losses so far of 2-4% against the yen, dollar, Swissie, sterling, and Canadian, Australian and New Zealand currencies.  It also crested during the quarter against the renminbi and is grinding lower but at a very gradual pace.  Lately, a number of other Asian emerging market currencies have trended higher, too. 

The dollar will face some continuing headwinds in the final quarter of the year.  One depressant involves recent monetary policy initiatives. 

  • Depreciation is a near-term objective of the Federal Reserve’s third round of quantitative easing announced earlier this month because that is the quickest acting channel of economic stimulus. 
  • The proposed purchase of peripheral Ezone sovereign debt by the European Central Bank is conditional and thus still uncertain from the standpoint of timing.  Moreover, the main thrust of the ECB’s proposal is to dissuade investors from believing that the common currency area is nearing a break-up, a psychology that previously depressed the euro to a low of $1.2041 on July 24. 
  • Although actions announced by the Bank of Japan Board revealed greater appreciation of and sensitivity to economic damage caused by the stronger yen, the BOJ will be stimulating on a smaller scale than the Federal Reserve.  Furthermore, the foreign exchange market reaction to the Japanese central bank’s easing was disappointing, though predictable in light of the failure to end deflation and accelerate money, credit, and real economic growth of numerous policy changes over the past two decades.  One wonders if even massive Japanese Forex intervention would produce a lasting difference.
  • The authorities at other central banks, such as those in Canada, Australia, and New Zealand would prefer to have their currencies be not so strong but accept that reality and are not preparing to try imposing a different equilibrium.

Another headwind for the greenback involves the U.S. election and the fiscal cliff that lurks beyond it.  President Obama isn’t offering significant changes from what’s currently in place, and second-term administrations have a propensity to founder in the United States.  Former Governor Romney represents a party whose increasing extremism scares a lot of people in America and abroad, and the candidate’s public image suffers on matters of competence, experience, and earned trust.  Opinion polls favor Obama more than they did six weeks ago, but the election appears way to close to call.  Congressional results are likewise finely balanced, so the degree of fiscal restraint in 2013 remains an utter mystery with potential scenarios that would make a U.S. recession unavoidable.  The balance of risks from U.S. political headlines in 4Q12 is skewed negatively despite the existence of conceivable developments that would be quite positive.

Anti-American violence in the Middle East has injected another dollar risk.  Countries in the Middle East hold considerable dollar sums as reserves.  Large dollar holders not in the region could be also persuaded to diversify their wealth further into non-U.S. denominations.  Energy prices tend to soften after the summer but might not do so because of the unsettled geopolitics.  Higher imported energy costs expose countries with sizable balance of payments deficits, like the United States, to more currency pressure. 

Even before the dollar turned lower this summer, the balance of payments showed lessening support.  Although America’s current account deficit of $117.4 billion in 2Q12 was 12% smaller than the first-quarter deficit and not as big as analysts assumed, such still equaled 3.0% of GDP, similar to the 3.1% of GDP deficit in the final quarter of 2011.  Moreover, direct investment and portfolio investment together produced a third straight quarterly outflow.   These accounts comprise the high-quality U.S. long-term capital flows that along with the current account reveal an economy’s fundamental currency support system.  In the pre-1973 era of fixed dollar parities against other currencies, analysts carefully monitored the current account, direct investment, and portfolio investment to gauge if exchange rates represented a sustainable market-clearing equilibrium. 

The breakdown below of direct and portfolio investment into their eight component parts shows who (U.S. or nonresidents, ie, fgn)  bought or sold what kind of asset.  “DI” is an abbreviation for direct investment, and “corporates” and “agencies” refer to U.S. corporate bonds and U.S. agency bonds.  The sum of the quarter-to-quarter changes in the right-most column below equals the $33.2 billion increase in net direct investment and portfolio investment outflows from $42.8 billion in first quarter to a sum of $76.0 billion in the second quarter.  In that column, a positively signed change indicates an increased U.S. net capital inflow, a reduced net outflow, or a swing from a net outflow to a net inflow. 

Billions of Dollars 1Q12 2Q12 Change
U.S. DI Abroad +116.1 +79.2 +36.9
Fgn DI in U.S. +22.2 +33.4 +11.3
U.S. + Foreign Bonds -18.4 -26.5 +8.1
U.S. + Fgn Stocks +14.8 +21.0 -6.2
Fgn + Treasuries +43.8 +7.4 -36.4
Fgn + U.S. Corporates -14.8 -33.3 -18.5
Fgn + U.S. Agencies -0.4 -1.3 -0.9
Fgn + U.S. Equities +18.9 -8.6 -27.5


A final possible dollar headwind is nothing more than seasonality.  A tendency for the dollar to fall somewhat more often than rise in the final third of each calendar year has been observed in the nearly forty years of floating exchange rates, and such has been more consistent than at other seasonns of the year.

It has been difficult this past month to discern a trend in currency movement from random market noise, caused in part by technical considerations.  It hasn’t been very rewarding to bet on economic fundamental grounds.  September-to-date dollar declines are not particularly large and have often been dwarfed in size by intra-day swings back and forth.  From a bird’s eye view, EUR/USD looks pretty stable around $1.30, and the yen remains in a 78-80 per dollar range.  The Swissie is near the 1.2000 per euro ceiling established by Swiss central bank officials slightly more than a year ago.  The Canadian and Aussie dollars remains not far removed from U.S. dollar unity.  Sterling set a 5-month high against the dollar this week but did not leap there.  At this time when no government wants an especially expensive currency, verbal remarks intended to prevent cumulative one-way strength are an ever-present event risk, and the dollar could get a fillip should Europe’s debt crisis re-intensify substantially, or if Japan intervenes conspicuously.  Even in the best imaginable dollar scenario, one doesn’t hear predictions of a one-to-one dollar for euros parity later this year as some predicted a few quarters ago.  And for the second year in a row despite the advantage of a better growth outlook than other economies face, the dollar is failing to reach the highs that optimists were expecting.

Copyright 2012, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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