The buck stops where? How a tattered dollar could quickly lose further allure

The buck stops where? How a tattered dollar could quickly lose further allure
By Peter Garnham and Chris Giles and Christopher Brown-Humes
Copyright The Financial Times Limited 2006
Published: November 28 2006 02:00 | Last updated: November 28 2006 02:00


Christmas shopping in New York is usually thought of as an expensive indulgence rather than a bargain hunter's dream. But this year, there are savings to be had if one is spending euros, sterling or yen. With the dollar suddenly sliding against all the main currencies, shoppers in Europe and Asia are being told they can get their iPods, Nintendo Wiis and Armani suits cheaply if they buy them in the US.

Anyone tempted to make the trip a week ago will be even more tempted now - the dollar went on to register its worst week since June, falling 2 per cent against the euro and 1.9 per cent against sterling. Yesterday it hit a 20-month low of $1.3180 against the euro and a two-year low of $1.9465 against sterling, meaning it has fallen 10.8 per cent against the European single currency and 12.4 per cent against the pound this year.

Last week was significant in that the dollar breached an important barrier, according to traders. Since May, it had been relatively stable within a euro trading range of $1.25-$1.30. Its fall outside this range left investors wondering whether that was simply due to a lack of liquidity around the Thanksgiving holiday or the start of a more sustained slide in the US currency.

"The violence of last week's move was exacerbated by thin trading conditions, but it was driven by fundamental factors which aren't going to go away any time soon," says Simon Derrick, currency research chief at Bank of New York. According to Mr Derrick, one factor weighing on the dollar is a growing feeling that after two years of sustained increases, the next move in US interest rates will be downward, as inflation falls in the face of a slowing economy. Falling US interest rates - or the mere expectation of them - tends to lower the demand for dollars, as investors seek higher returns elsewhere.

The Federal Reserve increased US rates by 425 basis points to 5.25 per cent between June 2004 and June 2006. This provided strong support for the greenback at a time when interest rates in Japan were virtually zero and when they were stuck at 2 per cent in Europe until last December. Market expectations, monitored by the Federal Reserve Bank of Cleveland, show that investors think there is a 30 per cent chance of a cut in US rates in March.

Just as it seems interest rates in the US may have peaked, they are being increased by the European Central Bank, the Bank of England and the Bank of Japan. The ECB is expected to raise its main rate from 3.25 per cent to 3.5 per cent at its December 7 meeting. The big question is whether Jean-Claude Trichet, ECB president, will signal further increases in 2007.

"Never since the birth of the euro in 1999 have we seen an environment where the ECB and the BoE are in the midst of an interest rate tightening cycle while the Federal Reserve is approaching an interest rate easing cycle," says Ashraf Laidi, an analyst at CMC Markets. "It is this unprecedented contrast in monetary policies that is behind the accelerating flows emerging against the dollar, even if the UK and eurozone rates are currently below their US counterpart."

BNP Paribas analysts forecast that the dollar will weaken to $1.40 to the euro by the end of the second quarter of 2007, based on a prediction that the Fed will cut rates by 100 basis points in the first half of next year. A $1.40 rate would take the dollar past its record low against the euro of $1.3548, struck in late 2004. At that time the markets' main concern, in the immediate aftermath of George W. Bush's re-election as president, was the massive US trade and current account deficits.

Those worries have not gone away. The US current account deficit this year is expected to reach $869bn (£450bn, €664bn) - 6.6 per cent of gross domestic product - according to International Monetary Fund data. To make up for this massive outflow, there must be a corresponding inflow into dollars, and these can no longer be taken for granted. While the US Treasury bond market was always an attractive home for foreign capital, this month the Treasury said foreign investors sold a net $374m in its notes and bonds in September, the first net sales since 2003.

An even bigger concern is growing talk of global central banks diversifying their foreign exchange reserves away from the US currency. One factor supporting the dollar has been huge purchases by foreign central banks. Since 2001, global currency reserves have soared from $2,000bn to $4,700bn according to the IMF, with two-thirds of the world's stockpiles held by six countries: China, Japan, Taiwan, South Korea, Russia and Singapore.

Anxieties over reserve diversification have been around for at least six months, with central banks in Russia, Switzerland, Italy and the United Arab Emirates announcing plans to cut the proportion of dollars held in their reserves. A shift by central banksaway from dollars would remove akey source of financing for the USdeficit.

Currency markets' attention was focused by reports this month that China, the world's largest holder of foreign exchange reserves, had breached $1,000bn in foreign exchange reserves. Analysts had expected the news to heat up the debate about the renminbi, which many of China's trading partners - particularly the US - believe to be undervalued. Were the renminbi to strengthen, this would drive down the US current account deficit and ease pressure on the dollar.

But Fan Gang, director of China's National Economic Research Institute and a member of China's monetary policy committee, saw things differently. He said the real problem the world faced was an overvalued dollar, not only against the renminbi but against all the leading currencies.

His comments come at a time when speculation is increasing that China, which is thought to hold 70 per cent of its foreign currency stockpile in dollars, is considering a fundamental change in its reserve allocation. These concerns were highlighted on Friday when Wu Xiaoling, deputy governor of the People's Bank of China, said Asian foreign exchange reserves were at risk from the dollar's fall.

Mitul Kotecha, head of foreign exchange research at Calyon, the French bank, says the issue is likely to put increasing pressure on the dollar in coming months. "The Chinese authorities are becoming increasingly nervous about holding too many dollars," he says. "Other central banks will be in a similar position and the dollar will be a growing casualty of such nervousness."

As if there were not enough factors weighing on the dollar, it traditionally performs badly in December against the euro and sterling as European companies repatriate their dollar earnings ahead of year-end. "We have already seen a lot of corporate interest to sell dollars," says Monica Fan at RBC Capital Markets. "I would not rule out the dollar dropping to $1.35 against the euro and $2 against the pound in the short term."

What of the political reaction? Policy-makers have learnt that making strong statements on currencies can cause unwarranted volatility in markets. Hank Paulson, the new US Treasury secretary, has stuck to the tried and tested formula that the level of currencies is set by the market and a strong dollar is in US interests. However, both Jacques Chirac, the French president, and Dominique de Villepin, his prime minister, have recently expressedconcerns about the euro's strength.

Others including IMF officials have long argued that the the US current account deficit is unsustainable and a lower dollar would help to unwind global trade imbalances.

But they worry that any adjustment might happen too quickly. The IMF's most recent World Economic Outlook outlines a scenario where "a much more abrupt and disorderly adjustment could be triggered by a worldwide reduction in appetite for US assets combined with a significantly increased interest rate risk premium". That would put a sharp brake on growth just about everywhere.