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September 17th 2007

Commentary: How far will the Dollar Drop?

When the US Dollar eclipsed its previous record low against the Euro last week, commentators immediately began painting doomsday scenarios for the beleaguered currency. On paper, the argument for a continued decline in the Dollar is quite strong, due to a sagging economy, surging current account deficit, the prospect of lower interest rates and turmoil in US capital markets. But, in practice, the Dollar remains the world’s de facto reserve currency, which begs the question: “how much-if at all-will the Dollar decline?”

Let’s begin by examining the state of the US economy.  At this point, economists have clearly identified the housing/real estate sector as a major weakness in the US economy.  Instability and an overall lack of demand have contributed to falling prices for real estate, which is eating into consumers’ disposable income, and hence threatens to bring down the rest of the economy.  In fact, the most recent employment data, which has become the most-watched piece of economic data in recent years, signaled that for the last 3 months, no new jobs were created in America, which is a tremendous cause for concern.

As a result, it is all but certain that the Federal Reserve Bank will lower its benchmark interest rate at its next meeting, perhaps by as much as 50 basis points.  While this may soften the impact of the sagging housing market on the rest of the economy, it
will also decrease the EU-US interest rate differential to only 75 basis points. In addition, the European Central Bank will likely raise rates at its next meeting, which means the differential will be further reduced.  Combined with general instability in US capital markets, brought on by weakness in mortgage-backed securities, foreigners are beginning to grow wary of investing in the US.

While a US economic recession would decrease imports and perhaps stem the growing trade imbalance, foreigners may still decide that it is too risky to continue financing the US trade deficit.

On the other hand, many Dollar bulls insist (correctly) that the Dollar remains the world’s reserve currency, and serves as a safe haven in times of global economic instability.  And in fact, the Dollar initially appreciated in value despite the turmoil in its securities markets. However, this upward trend seems to have been the result of a temporary shunning of risk, and since then, the Dollar has resumed its fall.  In short, both in theory and in practice, the evidence suggests that the Greenback can still fall much further against the world’s major currencies.

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Posted by Adam Kritzer | in Commentary, US Dollar | No Comments »

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