Weak Dollar Will Normalize Trade Imbalances and Unemployment

The best recent policy response to the financial crisis didn't come from the G20 but from the foreign exchange market. This week the dollar fell aggressively against many currencies, driven by an Australian rate increase and a report claiming Arabs, Chinese, and Russians were conspiring to stop pricing oil in dollars. But the dollar was set to depreciate anyway due to an increasing debt and a dovish Federal Reserve. A weak dollar will have a positive effect on normalizing trade imbalances, if it lasts.

A falling dollar is a great stimulus to the US manufacturing base. Historically, manufacturing profits are inversely related to the value of the dollar.

From 1990 to 1995, the dollar stayed around the same level. But in 1995, the dollar started rising steadily, eventually peaking in 2002 after rising 51%. During this time, exports decreased by half:
During this period, exports in China and Japan surged. China's reserves quadrupled and Japan's reserves almost tripled. (For more information, see Robert Blecker's paper, "The Benefits of a Weak Dollar" at the Economic Policy Institute.) The strong dollar also had a large effect on jobs. See this figure on the effect of China's artificially low currency on employment and trade:

The map below shows the damage per state (see Robert Scott's paper here). Note that politically sensitive states such as Ohio, Michigan, and Florida have suffered some of the biggest losses.
Simon Johnson from MIT wrote a recent article arguing the weaker dollar is a part of Obama's plan to win the midterm elections by stimulating the manufacturing industry. Simon says NY Fed President William Dudley's recent comment that interest rates would stay low for the foreseeable comment was timed to send the dollar lower after the Australian rate hike. If rates stay low in the US for longer than other countries, there is an opportunity for a carry trade between the dollar and a currency that is likely to increase rates sooner (e.g. Korea, Australia, China or Switzerland).

Fundamentally, the dollar has nowhere to go but down. With high fiscal debt, loose monetary policy, and trade deficits, the dollar is fundamentally unattractive. Furthermore, there is likely to be significantly less demand for dollars in the future. The second largest holder of US debt, Japan, is highly indebted (debt to GDP of 170%) and aging. The savings rate has been steadily decreasing and will continue to reduce demand. Furthermore, the number one holder of US debt, China, is actively (and publicly) trying to diversify from the dollar.

But while the dollar may go down and start to normalize trade in the short-term, there is reason to be skeptical that this will occur for longer periods of time. Asian nations will not let the dollar get too low. Already we have seen Asian countries respond to the falling dollar. Yesterday, the FT reported Asian central banks aggressively bought the dollar on Thursday. Thailand, Malaysia, Taiwan, Hong Kong, and Singapore made substantial purchases, though they merely slowed the dollar's decline. A key aspect of this intervention was that it was coordinated.

The Asian countries that intervened likely did so primarily to stay competitive with China, which re-pegged the renminbi to the dollar in July 2009. This re-pegging of the renminbi means that whenever the dollar significantly weakens, a large number of central banks must intervene if they want to compete with China. This could mean a floor for the dollar. It could also be a bullish indicator for US treasuries, as foreign central banks may buy treasuries to push the dollar higher.

Sterling's Attempt to Return to Normalcy

It’ll be interesting to see how Sterling fares against the dollar in the next couple weeks. After a sharp drop against the dollar in the fall, Sterling has rallied in May (see chart below). Sterling is currently at a critical point. There are two technical indicators traders will be watching closely. First, there is a support/resistance level at around 1.62 GBP/USD. Second, the 200 day moving average is set to cross the 50 day moving average soon. (It is a sign of upward momentum when a short term average crosses above a long term average.) Therefore, if Sterling continues its rally over the next week it is a good sign the strength of Sterling is sustainable.

Fundamental factors also make this an interesting time. First, the rally comes after UK Chancellor of the Exchequer Alistair Darling revealed a controversial budget that forecast high debt until 2018. The FT described it as a “gamble on a rapid economic recovery and severe spending cuts.” Second, S&P downgraded the UK’s outlook from stable to negative this Thursday. The market responded to this news with a strong sell-off; however, by the next day Sterling was higher than before the news. Fundamentally, Sterling should have fallen more than it did. The reason it didn’t give up its gains is Sterling is in the middle of a broader realignment against the dollar.

The Pound/Dollar example is important to watch because it is a demonstration of the strength of the currency market’s attempt to return to normalcy. Precipitated by the fall of Lehman Brothers, most currencies fell heavily against the dollar during fall 2008. The common consensus was that the dollar was a safe haven during perilous times, though some, like billionaire Jim Rogers (who is very bearish on the US economy, government, and dollar), argued the rise in the dollar came from currency speculators covering their shorts. Either way, as the idea of green shoots has become more widespread, the dollar has fallen in value. One metric to measure this is the CBOE volatility index (the Vix), which has risen and fallen with the dollar. It is not coincidence that Sterling rebounded from the S&P downgrade in the same week the Vix broke 30.

The current return to normalcy was attempted earlier this year in January, though gains in the euro, pound, and yen were quickly eliminated after further negative economic news. This return to normalcy has been a trend in many other asset classes as well. It will continue as further (relatively) positive economic data gives way to gains of hemorrhaged assets like the pound, the euro, corporate debt, and oil.