Does the falling US dollar spell doom?
This document is intended for the general information of financial advisers only. Fidelity does not authorise distribution to retail investors.
January 2008
The mighty greenback is not so mighty anymore. Since February 2002, the US dollar has slid by more than a third on a trade-weighted basis against the major currencies.1
Explaining why it has fallen is easy. In recent times, relatively weak demand for US goods and services as shown by the country’s large trade deficit (and hence current-account deficit) has put consistent downward pressure on the currency. In the second quarter of 2004, the US current-account deficit ballooned to 5% of gross domestic product and has stayed above this level since.2
To finance the trade deficit, the US has had to “borrow” from foreigners. This has occurred through massive foreign purchases of dollar-denominated assets (bonds, stocks, real estate, direct investment in companies etc.).
Generally, these foreign purchases have been more than sufficient to finance the trade deficit. But because much of the trade-deficit financing occurs through foreign purchases of US debt (Treasuries, corporate bonds, mortgage bonds etc), the attractiveness of debt securities relative to other global assets is critical.
That attractiveness has suffered recently for two main reasons. First, with the US economy weakening and the Federal Reserve lowering interest rates, yields on US bonds have become less attractive compared with other debt markets. Second, the sub-prime mortgage crisis and sell-off in other asset-backed securities have reduced demand for these significant categories of US debt.
There is some perception that a weaker US dollar points to a US economic decay and decline. In reality, a lower US dollar may offset some of the sources of weakness in the US economy. A weaker US dollar, for example, makes US exports cheaper for foreigners, providing a counter to the country’s large trade deficit.
On balance, most economists would likely argue that a weaker US dollar is a net positive for the US economy, as it acts as a self-correcting mechanism by making US businesses more competitive. It’s worth noting that real exports have grown at an annual rate of 8% since the start of 2004.3 US multinational corporations have enjoyed strong profits from their sales abroad, boosted by the falling US dollar, that have offset weakness in some areas of their US operations.
Where to now?
While it’s simple to explain the US dollar’s decline, predicting its outlook is fraught; even more so because foreigners now own more US Treasury bonds than US private investors. China and Japan alone account for roughly 20% of all holdings of outstanding Treasuries.4
Over time, foreign central bankers, such as those in China and Japan, may wish to diversify their foreign-exchange reserves into different currencies instead of hoarding them primarily in US dollar-denominated assets.
With massive amounts of US debt in the hands of foreign investors, it is a legitimate concern that if they lose interest in buying and holding US assets, the US dollar could fall further and trigger greater turbulence in global financial markets.
In this regard, there is a distinctive difference between an orderly decline in the value of the US dollar and a disorderly one. The most widely discussed nightmare scenario, which has shown no signs of occurring, is that negative sentiment for the US dollar could trigger a “disorderly” decline in the currency, leading to widespread selling and financial panic.
In this scenario, US dollar weakness could degenerate into a self-fulfilling panic where US dollar-asset holders dump their assets, further driving down the US currency and leading to additional US dollar-asset selling and US dollar declines.
In contrast to that dire potential outcome, the decline experienced up to this point has been relatively orderly.
Could that be changing? In August 2007, for the first time since September 1998, foreigners sold more US financial securities (stocks and bonds) than they purchased in a given month, liquidating US$35 billion (A$39 billion) of dollar-denominated investments on a net basis. Part of this sell-off was probably related to the July-August stock market correction, as foreign private investors sold a record amount of US equities. However, foreign central banks also sold a record amount of US securities in August, most of it being US Treasury bonds whose creditworthiness was not threatened by the mid-year credit crunch.
Future data will show whether this was an extraordinary event precipitated by the turmoil in the sub-prime mortgage markets, or the start of an accelerated trend of diversifying away from dollar-denominated assets.
The large US external debt does pose potential risks for the financial markets. However, foreign owners of US dollar assets would also suffer from a disorderly unwinding of the US dollar. It is therefore in no one’s interest that such an event occurs. Even if the foreign appetite for US dollar assets has weakened from peak levels, there are no signs thus far that demand has dried up altogether.
1 Haver Analytics, Federal Reserve Board, Fidelity Management & Research LLC (FMR).
2 Bureau of Economic Analysis, Haver Analytics, FMR
3 Bureau of Economic Analysis, Federal Reserve Board, Haver Analytics, FMR
4 Federal Reserve Board, Haver Analytics, FMR
