Dollar stumbles into 2008

The dollar will stumble into 2008 down but not necessarily out, according to many watchers of the world’s currency markets.

Last year the dollar continued its multi-year downward trend amid a toxic mix of negative cyclical and structural factors.

These included deterioration in relative growth and interest rate differentials between the US and the rest of the world as well as increased concerns over the health of the US financial system, which was in the eye of the storm as the credit crisis worsened and the US housing market faced collapse.

Diversification of central banks’ foreign exchange reserves away from the dollar and the potential exit from dollar pegs by Middle Eastern monetary authorities also took their toll.

Analysts say that, on top of all this, US officials in effect welcomed the fall as a means of supporting the economy, giving investors the impression that selling the dollar was a one-way bet.

Mitul Kotecha, at Calyon, believes that a number of the risks to the dollar have been overplayed and, in any case, may already be in the price. Looking ahead, he says, much will depend on the path of the US economy.

Should the weakness in the US economy turn into a full-blown recession, the likelihood of a rout in the dollar will increase substantially, analysts say.

Many analysts believe the Federal Reserve’s move to cut interest rates, combined with the past decline in the dollar and its boost to exports, will help the US economy avoid a recession.

“We believe that the rest of the world will not easily decouple from the slowing in the US economy and that, as growth expectations are revised lower outside of the US, the relative growth differential will move back in favour of the dollar,” says Mr Kotecha.

Analysts say that while there is broad consensus that the US economy will slow in 2008, there is less agreement on the effect on the rest of the world.

Hans Redeker, at BNP Paribas, says the idea that the US economy has decoupled from the rest of the world has been the main driver of the dollar’s recent decline. But as 2008 unfolds, markets will conclude that decoupling will be less distinct than previously thought, boosting the dollar.

“After years of being dollar bears, we see it coming into demand,” says Mr Redeker. “The dollar’s decline, especially from February to November, has been built on the decoupling idea. As it does not materialise, the dollar will catch up.”

US households have about $300bn invested in non-dollar denominated securities. When global growth disappoints, these funds will be repatriated into dollars, Mr Redeker says.

He notes increasing signs that Asian countries that manage their exchange rates, especially China, will allow their currencies to appreciate in the face of mounting inflationary pressures.

Once Asian currencies move higher against the dollar, other free-floating currencies will see less demand from Asia, triggering their decline not only against Asian currencies but also against the dollar.

David Woo, at Barclays Capital, expects the euro to be rangebound between $1.40 and $1.50 against the dollar in 2008. He says investors can profit from the fact that some countries, notably the UK and Canada, will be more affected by a US slowdown than others.

“We view the underperformance of the pound and the Canadian dollar as consistent with the fact that the business cycles of the UK economy and the Canadian economy have been historically more correlated with the US,” he says.

On the yen, analysts expect it to benefit from a slowdown in global growth in 2008. It has underperformed during the recent period of global expansion.

Derek Halpenny, at Bank of Tokyo-Mitsubishi UFJ, says declining interest rate differentials between the US and Japan and the upturn in volatility have undermined the appetite for carry trades, in which the low-yielding yen is sold to finance buying of riskier assets. And negative economic conditions in Japan are likely to discourage risk taking.

“Greater investor caution by Japanese households will reduce appetite for foreign currency at least until dollar/yen falls toward the key Y100 level,” he says. “Our 2008 target is Y103.”