A case for longer-term dollar weakness

The FX markets have been buffeted by the disparate forces of risk aversion and risk appetite for sometime. Risk appetite translates into the dollar being sold as the market seeks greener pastures while risk aversion sees a safe-haven flight into the greenback. While one cannot be sure as to how long this will continue, it might be interesting to speculate at what’s in store for the US dollar once the markets revert to some semblance of normalcy.

China is the largest holder of the US unit with their reserves estimated at over 2.5 trillion and a weakening dollar cannot be to their liking. It is highly unrealistic to think that they can “trade” their way out of this position which means that they have to either hold it or spend it. Since the dollar is the world’s sole reserve currency and can be used to buy any asset in any country, it is imperative (from a Chinese point of view) that the US unit NOT lose its value dramatically. Hence their willingness to intervene and prop up the dollar which maintains the buying power of their “investment” while also allowing them to retain their competitive edge in the exporting arena. This strategy forces the other export driven economies (namely emerging market countries) to also follow suit and weaken their currencies in order to keep pace with the Asian juggernaut. The end result of all these machinations is that the dollar is kept artificially stronger and US exports suffer as they become more expensive and less competitive.

China is being pressured by the US and EU to halt this practice of debasing its currency but the Chinese seem to be in no hurry to accommodate these “requests”. This leaves the US with a very huge problem on their hands as the slow down of exports detracts from their efforts to try and reduce the deficits. To combat this the FED can either raise taxes, which is not a prudent option given the fragile state of the US economy, or devalue the dollar, which would make the debt worth less. Factor in that the US interest rates are close to their all-time lows, a byproduct of safe haven flows into the US debt market, and you have a climate that is not conducive for dollar strength.
So, a combination of low domestic yields, whether they are due to global risk aversion or foreign central bank manipulation, and the expectation of additional quantitative easing (QE2) measures being adopted by the FED should put inexorable pressure on the US dollar to weaken on a multi-month time horizon. Of course the global markets would have to calm down dramatically from the current fear-driven schizophrenic state for this scenario to come to fruition.

Akhilesh S. Ganti
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