Whither the Dollar - Or, Will the Dollar Wither?

 |  Includes: UDN, UUP
by: Dr. Scott Brown

Excerpt from Raymond James Economist Dr. Scott Brown's latest economic commentary:

Wide federal budget deficits and highly accommodative monetary policy have led to some worries about a weaker dollar. However, there are many forces at work behind exchange rates. Will the dollar weaken in the quarters ahead, hold its own, or possibly rally? Let’s take a look.

First, where have we been? After rallying in the early part of the last decade, the exchange rate of the dollar weakened heading into the financial crisis. The crisis led to a boost in the dollar as a safe haven (in addition, there was a bid for dollars to cover expected losses in dollar-denominated securities, including derivatives, held abroad). With global economic conditions having improved considerably over the last year, the dollar moved back toward its pre-recession level.

The exchange rate of the dollar is a price, determined by supply and demand. Trade and capital flows in and out of the United States are huge. In the U.S., we have a net trade outflow and a net capital inflow – and these two theoretically balance (the dollar moves to equate the two).

The current account deficit (which is mostly the trade deficit in goods and services) has a significant long-term impact on the dollar. The rise in the current account deficit in the last decade meant that the U.S. had to attract more net capital inflows to keep the dollar stable. The current account deficit peaked at 6.5% of GDP in 4Q05. The softer dollar resulted in some increase in imported inflation, but also dampened imports and made U.S. exports more competitive. The current account deficit had been improving ahead of the global financial crisis, but that improvement accelerated sharply as the global economy weakened. As a consequence, the U.S. needs smaller net capital inflows than it did before the crisis to keep the dollar steady. The current account deficit is now widening again – a long-term negative for the dollar.