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Greenback fighting a massive downward pull

The re-pricing of risk and assets classes due to the collapse of Dubai World may cause a temporary reversal of the carry trade that has favored the euro and emerging market currencies. Risk aversion among investors may cause the dollar to soar, yields on U.S. Treasuries to fall and the price of commodities to plummet. However, an increase in the value of the greenback is likely to be a transitory event. Due to a confluence of structural deficits and government policies, the dollar is undergoing a long-term adjustment in its value versus its major trading partners. Since 2002 the dollar index has fallen 37.6% and the greenback has declined 74.7% against the euro. Near term turbulence in global financial markets will not alter that reality.

The downdraft in the dollar is being driven by several factors. The current administration has adopted a policy of benign neglect regarding the dollar to obtain short-term economic gains. The Federal Reserve intends to keep in place its near zero interest rate and credit easing policies, even as other central banks exit their accommodative policies. Thus, increasing rate differentials will exacerbate further downward pressure on the dollar. The explosion in spending under the Obama administration is causing international investors to openly question the sustainability of U.S. fiscal policy and the long term role of the dollar as the global reserve currency.  

Our outlook on the dollar is bearish. Past bouts of dollar weakness concomitant with recessions strongly suggests that the greenback will not see a sustained recovery until at least 6-12 months after the Fed embarks on a rate hike campaign. In 2010 we expect the euro and the yen to respectively rise to $1.60 and ¥80 against the dollar. The dollar index, closely watched by the trading and speculative community, will fall to 70 next year. Although there will be substantial volatility in foreign exchange markets in coming months, we do not anticipate that investors will flock to dollar denominated assets in large numbers.

This contrarian view puts us in the minority of the foreign exchange community. The consensus outlook among Bloomberg forecasters is that the euro will peak at 1.51 versus the U.S. dollar during Q1 and that the yen has already peaked and is headed lower through year end and towards 101 by the end of 2010.

The dominant view of the consensus is that the dollar will retrace losses as soon as the Fed terminates its temporary liquidity measures and declares a formal end to its long term asset purchases program. But due to excess liquidity sloshing around the global financial system, the paring back of credit easing programs will not be sufficient to stimulate a dollar rally. The sharp increase in cost of credit default swaps for select countries and flows of capital into dollar denominated assets due to a possible default by Dubai may be dollar positive factors in coming days. However, this event it does not alter our long-term outlook on the dollar.

The long term prospects for the dollar remain bleak. The twin deficits of the US budget and current account arrears will act as a drag on any near term recovery in the dollar. The U.S. budget deficit is on track to exceed $1.5 trillion and could conceivably grow much larger if the ambitious spending programs of the current administration and Congress are put into place. Although the current account deficit has improved due to the recession, that improvement is subject to reversal as a result of the cyclical recovery in trade.  

Also weighing on the dollar is talk that the greenback's role as the primary reserve currency needs to be curtailed, supplanted by a shift in reserve holdings to either some international currency or to a diversified basket of currencies based on trade flows. A decline in the value of the dollar has stimulated a bout of diversification away from the greenback.

Through the second quarter of 2009, the most recent reporting period, central banks that disclose their holdings put 63% of the new allocations into euros and yen. Given the rapid deterioration in the U.S. fiscal position, it is not surprising that calls to replace the dollar as the primary unit of transaction in the global economy are proliferating.

The ability of policy makers to prevent further dollar deprecation within the context of a zero interest rate policy is limited. The most effective measure that the administration could take would be to make a credible, clear and transparent commitment to reducing the size of the annual operating deficits and federal debt. We are not holding our breath.

Second, count on the Fed could continue to jawbone currency markets to effectively mitigate the dollar's decline. Finally, the central bank could move in concert with the European Central Bank, the Bank of Japan and the People's Bank of China to intervene with money on the table in market hours to effectively put a floor under the dollar. Give the recent failures of President Obama and ECB President Jean-Claude Trichet to convince the Chinese to revalue the yuan that appears unlikely.

It is clear that the current administration does not yet possess the credibility to effectively shape global market expectations on a sustained basis. There is an expanding gap between the President's rhetoric and his policies on deficit reduction. The sharks are circling Treasury Secretary Geithner, and Congress is targeting the independence of the central bank. These are not conditions conducive to stemming the long-term depreciation of the dollar. Perhaps this sorry state of affairs is best summed up by former U.S. Treasury Secretary John Connelly, who during another time of dollar weakness stated "It's our currency, but it's your problem."

Joseph Brusuelas is a Director at Moody's The ideas expressed here are his own and do not represent the views of his firm. T.J. Marta is the founder of Marta on the Markets, a financial markets research company. Their book Forex Analysis and Trading is available from Bloomberg Press.

Disclosure: none