With discussion at this week’s World Economic Forum in Davos, Switzerland focused on the global impact of the dollar's decline, one could be forgiven for thinking that the danger of a dollar meltdown is weighing heavily on Wall Street’s best and brightest. But not everyone is worried.
The dollar has lost about a third of its value against major currencies over the last three years, and the consensus view on Wall Street is for the currency to weaken further in 2005 as the U.S. deficit continues to grow.
But there are a number of contrarians on the Street. They're expecting a dollar rally in 2005, saying that the growing U.S. economy will keep it buoyant. They also point to expectations for a strong improvement in U.S. exports in 2005, which will boost the greenback, and they say that dollar bearishness has become far too widespread.
“Everyone’s convinced the dollar’s going to go down, and so from a supply and demand standpoint we’ve reached a point where we have exhausted bearishness,” said Chip Hanlon, president of Delta Global Advisors. “So everyone who wants to be out of the dollar is probably out of it by now and demand should have a relatively easy time of taking charge here.”
Expectations for a weaker dollar are so pervasive that they now provide fodder for sketches on late-night comedy shows. Indeed, a recent skit on NBC’s “Saturday Night Live” lampooned the venerable U.S. dollar, the world’s leading currency, for its recent weakness against the euro, the Japanese yen and even the Mexican peso.
But the point is well-taken. Not counting its revival in recent weeks, most notably against the euro, the dollar has lost about 35 percent of its value against the euro and some 25 percent against the Japanese yen over the past three years, dogged by investors’ concerns about the widening U.S. current account and budget deficits.
And at the Davos meeting this week, economists, politicians and business leaders expressed their grave concern about the imbalances in the global financial system, highlighted by the dollar’s weaknesses.
The cheaper dollar has boosted U.S. exports, but it has led to tension between the United States and its trading partners in Europe and Asia. The falling dollar has hurt European and Asian exporters to the U.S., forcing them to either raise prices or accept smaller profits. Meanwhile, the Bush administration seems willing to tolerate the dollar's slide.
“I expect the dollar to see one more leg down in the first quarter, and then move higher for the balance of the year,” said Peter Cardillo, chief strategist at New York brokerage S.W. Bach. “That’s really because we haven’t seen a policy decision from Washington. There’s rhetoric there about a stronger dollar, but little has been done to turn the tide. But in the end, I think it will be an up year for the dollar because I think it’s undervalued from a fundamental point of view.”
In the United States, there are straightforward economic reasons for dollar strength in 2005 according to Delta Global Advisors’ Hanlon. One is that the Federal Reserve is raising interest rates, which tends to boost the dollar by attracting foreign investment into dollar-denominated securities. At the same time, foreign central banks are at end of their tightening cycles, which tends to make their currencies less attractive investments.
“Lots of people think the dollar bounce we are seeing now will last for a few more weeks. I think it will last for at least year,” Hanlon said.
Hugh Johnson, chief Investment Officer at First Albany, points to similarities with the period between 1985 and 1988. During those years, the dollar declined about 40 percent on a trade-weighted basis, he says. Shortly after, U.S. exports grew faster than expected, and the trade balance declined as a result. Johnson expects to see a similar pattern emerge in 2005.
“An improvement in exports and business spending should drive the U.S. economy in 2005, and so the appeal of dollar-denominated assets will improve. And I think there’ll be a rise in exports that is stronger than expected. The consensus is for a rise in exports of 9 or 10 percent, but I think it will be more like 12 percent and in time we will see the U.S. dollar stabilize, or improve in 2005,” said Johnson.
What’s more, some foreign manufacturers have responded to dollar weakness by raising prices, Johnson added. That may encourage the Fed -- which is always on the lookout for inflation -- to raise interest rates faster and in doing so shore up the dollar.
Longer term, the dollar’s price level is likely to be determined by its relationship to the Chinese yuan, said Steve Stanley, chief economist at RBS Greenwich Capital.
China has been under pressure from U.S. and European officials to move away from its policy of pegging the yuan to the dollar, which many U.S. manufacturers argue gives Chinese imports a competitive advantage in U.S. markets. But this week at Davos, Chinese officials indicated they are unlikely to undertake any sweeping revaluation of the yuan this year.
“I think we’re going to see the Chinese continue to take baby steps to liberalize their currency; they won’t pull the trigger in 2005, and so we’ll get more of the same for the dollar this year,” Stanley said. “I think the dollar will be more stable in 2005 and won’t move a lot in either direction.”