Where will the US dollar go from here?

Since mid of July, the US dollar has been showing signs of appreciation. The US dollar index went from 72 points to 77 points, increased by about 7%. But after mid of August, it went through a short period of correction. Last Friday trading day saw it went up to 76.11 and then goes up from there with a new high on 26 August.

The recent rise of the US dollar does not seem to be caused by any related good news to the US dollar. It is because the non US dollar based region's economy have not beeng doing well. From figures, Euro region 2Q economy has shown a drop of 0.2% in growth and at the same time import and foreign investments have decreased. Euro's June account deficit has grown to about 8.2 billion Euros. From the figures, we can see that Euro's economic situation is worsening. There is a drop in economic growth. Japan's June export and consumer index are also showing big declines. Japan's 2Q economic growth is -2.4%.

Short term (coming 1 to 3 months) trend for the US dollar should be in stagnant. There up and down trend is limited.

From the US economic situation, currently it still has not come out from the bottom. Although after various interest rate cuts, US housing still have not shown signs of recovery. June's existing home sales fell 2.6 percent in June. Housing permits shows a 17.7 per cent drop from June. The bad housing situation in US makes it difficult for US to get out of the bad economic situation and it may further worsen the US credit crisis.

The US credit crisis started from the 2007 sub-prime related debts, where their gradings have been constantly downgraded since then. The worry is that it may propagate to the prime related area in the coming months. When unemployment starts to get worse, credit card spending are still high. As unemployment gets more worse, the bad debts from credit card spending will increase. Prime housing loans are also showing signs of late payments. This will cause smaller banks to face worsening financial situation.

From US monetary policy stance, since the 90s, the US monetary policy main aim is to counter inflation. However, from 1991 to 1993, US inflation was on the up trend but US did not trigger any interest rate increment. In 1992 September there was even an inerest rate cut. After 'observing' for about 1 and half year or so, in 1994 February then there was the trigger of interest rate increment. The situation from 2000 to 2004 is also the same. In 2002 2H US inflation starts to rise, most economist were expecting then that the FED will start to increase interest rate. But in 2003 June the FED continues to cut interest rate by 50 basis points, beating market expectations. Until 2004 June where inflation continues to rise that the trigger for interest rate increment was started.

From the looks of things currently, with the stabalising of crude oil and commodities, inflation should be coming down and the FED may further cut interest rates to help save the ailing housing market and the falling economic situation. The moves will limit any further up trend for the US dollar.

But becuase of the falling economic situations of the other non US dollar based countries, the down trend of the US dollar is also limited. Tightening measures to control inflation and drop in external demands have caused the economies of the other non US dollar based countries to drop quite a lot. As inflation is still high for those countries at the moment, tightening measures or policies will continue. The economic situation of the other non US dollar based countries will continue to worsen thus providing support for the US dollar.

Mid term (coming 1 to 2 years) should see the US dollar on the up trend.

EU and Japan still needs time to get out of the current declining economic situation. Coming 1 to 2 years will not see them getting out of the declining economic situation. These 2 big economic bodies ability to tackle inflation is less then US as currently they cannot use an expanding monetary poilcy or fiscal policy to stop the declining economic situation. If there are no good measures to stop the worsening economic situation, it will only increase the economic decline time frame and the degree of it. The short term US dollar back flow is good for the recovery of the US economy. When US economy shows signs of recovery and the other non US dollar based economic bodies are still worsening, there will be more back flow of the US dollar, which will aid the recovery of some US industries causing the US dollar to strengthen.

Long term (2 years from now) trend for the US dollar is unclear. With the recovery of the US economy, the rest of the other countries should start to recover. If the US dollar were to continue the up trend, there needs to be some bright spots in economic growth.

Current US deficit is 1.9% of GDP. In future room for using tax cut to stimulate economic growth is still quite big. If the next economic growth still relies on high spending, then the US dollar will head back down as more spending in US will cause the deficit to increase also causing the export of Euro and Japan to increase helping them with the economic recovery causing the US dollar to weaken.

If like the 90s US have some major technological advancement which can lead the economic growth, the next economic growth for US will continue to support a strong US dollar. However, currently there is no such technology or industry which shows the potential to do so.

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30 August 2008

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