It is difficult to predict the dollar because there are few different factors pulling the dollar in different directions.
Firstly, the dollar has been surprisingly resilient since the US slipped into its worst recession and US interest rates tumbled to near 0%. The resilience of the dollar is not based on economic fundamentals but, a general unwinding of positions and the ‘dash for cash’
Firstly, the dollar benefit from hedge funds and investment trusts deciding to get out of emerging economies. As they sold securities in emerging economies they generally were sold for dollars increasing demand for dollars.
Secondly, the prospect of deflation means that people are wanting to hold more cash. In many economies it is the dollar which is seen as the reserve currency, so there has been an increase in demand for dollar holdings as security against deflation and falling curencies.
However, these factors may be coming to an end and Economic Fundamentals point to a weaker dollar. The US
- Interest rates close to 0.5%. Yields on short term treasury bills is close to 0%. Therefore, there is little incentive to save in the US banks
- Increasing National Debt in the US. US public sector debt is already over 73% of GDP and rising quickly due to recession, government bailouts and stimulus packages. As public sector debt pushes towards 100% markets may have less confidence in the government’s willingness to repay debt without inflation. If this occured it would cause an outflow of money from the US and a big depreciation in the dollar.
- Increased Money Supply. Due to declining velocity of circulation, the US treasury has been able to increase monetary base without any inflation. The danger is if the velocity of circulation unexpectedly increased – this large rise in the monetary base could translate into very high inflation.
- Large Current Account deficit. The US has had a persistent current account deficit. This has fallen in recent years. However, the global credit crunch may make it harder to attract capital flows and therefore, this would require a depreciation in the dollar to reduce the current account deficit.
- Other Factors to Bear In mind.
- The Euro has been very strong recently, but, the Euro economy is also in recession; it is likely EU interest rates will fall as well; they may only be marginally above US rates. The high value of the Euro could cause problems for EU exporters.
- Purchasing Power Parity. ON measures of purchasing power parity, the US dollar is not overvalued. Goods in US still appear cheaper than in Europe or Japan.