Opinions on the future fate of the dollar differ in the extreme. Will the bulls or the bears win out? William Essex reports on factors weighing against the currency and those that could boost it.

When the dollar moves, the world watches. The big question for holders of dollar assets and currency managers is: where does the US dollar go from here and how quickly will it move? Opinions differ widely. If there is any consensus, it is that the dollar will probably weaken further but the trend is slowing and there is an upturn due near the year-end. However, the consensus is weak and there are plenty of extreme views that are poles apart.

Michael Rosenberg, head of foreign-exchange research at Deutsche Bank, says: “The dollar has always exhibited a tendency to rise and fall over long-term cycles that typically run for five years. Historically, the dollar tends to overshoot. We are expecting a 20%-25% overshoot on the downside relative to PPP [purchasing power parity]; in 2000/01, the dollar overshot on the upside by 30% against the euro.” This down-cycle is underpinned by strong fundamentals, he says, and estimates that the downside overshoot will hit its floor in about 2006.

At the other end of the spectrum, Craig Reeves, managing director of hedge fund Platinum Capital Management (and a former FX trader), believes that the US dollar has a “fantastic future” and that it will not fall much further. “I think we’re very close [to that level] now,” he says.

Mr Reeves also suggests a long-term cushion for Mr Rosenberg’s projected overshoot. “Every commodity in the world is priced in dollars. Despite the fact that everybody is buying gold, they have been buying dollars to buy that gold. They have been buying dollars to buy oil,” he says.

  Michael Rosenberg: expects a dollar overshoot ‘The dollar has always exhibited a tendency to rise and fall over long-term cycles that typically run for five years’ 

Inbuilt advantage

So, for as long as dollar denomination for commodities lasts, the dollar has an inbuilt advantage. The substance of the disagreement between Messrs Rosenberg and Reeves is as much about timing as it is about direction, and on that there is widespread caution.

Thanos Papasavvas, head of currency at Credit Suisse Asset Management (CSAM), suggests that the market’s own momentum may be a factor there. “What we have seen over the last two years is the gradual correction of the dollar against most of the other majors. The macroeconomics now suggest that the euro, sterling and the Australian dollar are overvalued. But the market dynamics are such that this does not seem to be the end of the range,” he says.

Bears in charge

The dollar bulls have made their case, but their sentiments have not so far affected buyers in the market.

Mr Papasavvas says: “We [CSAM] are scaling down our risk; we have scaled down Australian dollar and sterling.” However, even as he carries smaller positions of more currencies, he admits that this is more to do with enhancing portfolio diversification rather than reflecting his long-term view about the US dollar. Predictions of next year’s valuations are not yet certain enough for many to commit their money.

Mr Papasavvas’ opinion is also significant in that, given his macroeconomic view, he is effectively suggesting that Mr Rosenberg’s overshoot is already happening. He is not, however, calling the turn, and his caution is strong enough to have no intention of doing so. He is prepared to miss out on the first gains of a dollar rebound to ensure he misses any selling spree that the dollar’s rise might encourage.

“The correction of the dollar is not over yet. If and when the trend changes, understandably we’re going to lose the first, second and possibly third month, and then we’re going to follow through [buy dollars again]. We would rather lose the turn and catch it on the other side than try to predict when that turn is going to come,” Mr Papasavvas says.

Federal Reserve’s role

Central to any such prediction would be the US Federal Reserve’s (Fed) attitude to US interest rates. Paresh Upadhyaya, a currency analyst at Putnam Investments, detects signs that the Fed is preparing the market for a policy change. For him, the Fed’s shift from a November 2003 stated policy of “keeping interest rates low for a considerable period” to a January 2004 statement omitting the qualified period at the end of the statement, is one of a series of subtleties that collectively indicate change is on the way.

Similar utterances from such institutions as the European Central Bank reinforce that impression. Indeed, Mr Upadhyaya is prepared to commit himself to a prediction: “The risk of higher rates in the US increases in the second half and is most likely in the fourth quarter. By then, the Fed will have seen five or six months of solid growth in employment.”

Wall of money

Mr Upadhyaya also makes a wall-of-money argument – in which investors have so many non-dollar assets that when the dollar rises, there will be a tidal wave of money flowing to the dollar because people are afraid they will miss out on any upside. “When the Fed gives us the hint that it’s about to begin the tightening cycle, you will see the dollar begin to move very quickly, simply because everybody’s long everything else except the dollar,” he says.

Despite the Fed’s subtle semantics, in Mr Upadhyaya’s view, the “hint” stage has not yet been reached. He concedes, however, that downward pressures on the dollar are set to continue, including the growing size of the current account deficit and the budget deficit.

This is where the debate becomes complex. “The US current account deficit now stands at over 5% of GDP and is the largest in the world, yet the US has one of the lowest interest rates in the world,” says Mr Rosenberg. “How do you attract capital to finance this mammoth deficit?”

The obvious answer is by raising interest rates; that would also address the potential flaw in the wall-of-money argument – which is the risk that, without the additional incentive of higher interest, the attractions of diversification will see cash flow into other currencies and not the dollar.

The bigger picture

There is more to the debate than what is going on in the Fed’s collective consciousness, however. The bigger picture begins with the politics of the macroeconomics. Paul Chappell, managing director of C-View, says: “The US seems pretty comfortable with a weak dollar as part of its effort to assist the US economy. There has been a great enthusiasm to keep interest rates low and to keep the dollar weak to stimulate the economy and improve President Bush’s re-election prospects.”

There are other political factors also weighing in, including the possible threat of election-motivated protectionism, the benign effect of a weak dollar on the trade deficit, and the long-term strategy uncertainties that would arise if the presidential election is a close run race.

The weak-dollar policy clearly is not dead yet, although perhaps it should be. Mr Chappell says: “There are some signs that inflationary forces are building up in the US. The longer they spend avoiding raising rates, the more painful an interest-rate hike will be in the future.”

If inflation takes hold, and particularly if economic growth does not materialise, many believe that even a later, higher rate hike might not lift the currency. Thus there is a case for reading the runes at the White House as well as at the Fed. “There’s a prospect that the fiscal stimulus applied in 2003 will not be there in 2004, which means that growth would have to come from elsewhere and would probably be slower,” says Mr Upadhyaya.

But most of the space in the bigger picture is taken up with another factor: China. Recent growth rates of about 8% a year in China are projected to fall to about 4%. Such a slowdown would have an impact on regional economies and stock markets, and it might alter Chinese currency strategy. The renminbi is pegged to – or more strictly, managed against – the US dollar, which gives other Asian economies an incentive to manage their currencies against the renminbi to maintain competitiveness.

There is political momentum in the US to persuade China to free the renminbi because, some people say, the peg delivers an “unfair” trade advantage. Against this, there is an economic argument that China’s strategy of buying US treasuries to maintain currency stability (China holds more than $120bn in US debt) is a key factor in financing the US deficits.

Other forces

Other forces are affecting the dollar’s trajectory. In Russia, for example, the central bank is buying dollars in an attempt to slow the rise of the rouble. And Japan has also been buying US debt.

“Japan and China between them hold 20% of all US treasuries. If the dollar falls further, they will have to support it to protect their investment,” says Mr Reeves.

That is yet another cushion beneath the dollar – but if the peg breaks and Asian currencies are no longer managing towards weakness, any dollar rise might be hampered by a sell-off. Non-US holders of US dollar-denominated assets face a clear need to hedge out their currency exposure. This is also a good time to diversify. But might it also be a good time to speculate? How about taking a long look at Asia?

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