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Why the greenback is back
Remember all those dire predictions about the dollar crumbling in 2005? Fact is, it's been rising all year. Here's why -- and why the rally may stall in 2006.
By Jim Jubak
The U.S. trade deficit for September: $66.1 billion.
A new record and up almost $7 billion from August. With the U.S. now importing 63% more than it exports, nobody is projecting that the trade deficit will drop below $60 billion a month anytime soon. For the year, the total could well pass $700 billion, easily trumping the record $665 billion trade deficit of 2004.
And yet the U.S. dollar rallied on Nov. 10 in the face of the day's bad news of this soaring trade deficit. The U.S. dollar now stands near a two-year high against the euro, the European currency that was supposed to supplant it. And you have to go back to September 2003 to find the last time the U.S. dollar was this strong against the Japanese yen.
Remember back at the end of 2004, when pundits were falling over themselves to predict disaster for the U.S. dollar in 2005? I sure do, because I was one of the folks predicting a dollar decline in 2005. I had seen the error of my ways and reversed my opinion on the dollar in my June 14 column, "Why we were so wrong about 2005." So, I was only wrong on the dollar for half a year. But I still never imagined the dollar would post something like a 15% gain against the euro at this point in the year.
A method to the dollar madness
So what's going on? Currencies are supposed to tumble in price when trade deficits climb this high.
There is a logic to the dollar's rally, though. I'll spell it out for you and then tell you how I think this logic will play out for the tail end of 2005. And explain why you should look out for a turn in the dollar's fortunes in 2006. I'll finish with some suggestions on how to profit from the dollar's current strength and the turn I see ahead in 2006.
Related news and commentary on MSN Money
Three reasons explain the dollar's surprising rally this year:
The dollar's up because the euro is down
The U.S. dollar doesn't have to be a perfect currency; it just has to be better than the competition, the euro. (The yen, given Japan's negative real interest rates, isn't a starter in this race.) And it would be hard over the last six months to find a currency that's suffered more body blows than the euro.
There's the France problem: The country's immigrant population has risen up in protest against problems that include 40% youth unemployment, and the French government has shown itself startlingly clueless about how to stop the rioting and fix the underlying problems.
There's the German problem: Everyone (well, investors and economists, anyway) got excited that the fall's election might sweep a new government to power with a mandate to transform the country's rigid economy. Instead, the vote went just about straight down the middle, leaving the country to be governed by a grand coalition that doesn't agree on much of anything.
There's the Italy problem: The country's budget deficit is way, way above the rules set by the European Union, and, with the Italian economy struggling to grow at all, nobody in Rome really wants to propose budget cuts.
And finally, there's the United Kingdom problem: The Tony Blair government saw its anti-terrorist legislation go down to brutal defeat in the House of Commons on Nov. 9, just in time to undermine Blair's ability, as president of the European Union for six months, to broker a deal on the EU budget. Talks on the budget collapsed in June with Britain and France at loggerheads.
That's enough to make anyone think twice about buying euros, no?
The Fed has made it pay to buy dollars
Alan Greenspan may find it painfully puzzling that the Federal Reserve's interest-rate increases, which have taken short-term rates from 1% in June 2004 to 4% currently, haven't pushed up long-term interest rates significantly. But, at the Nov. 10 close of 4.56%, the yield on the U.S. 10-year Treasury note is significantly higher than investors collect on either European or Japanese bonds. That day, the 10-year German bond was yielding 3.51%, and the Japanese government's 10-year bond was paying 1.57%. (The U.S. bond market was closed on Nov. 11 for Veterans Day.)
Any wonder, then, that the U.S. Treasury's auction of 10-year notes on Nov. 10 was massively oversubscribed, with $29 billion in bids for the $13 billion in bonds offered? If foreigners are so willing to buy our IOUs, why is the size of the trade deficit something to worry about? Pretty much sums up the attitude on Wall Street.
High oil prices aren't just a problem; they're also a solution
High oil prices added about $1.5 billion to the trade deficit in September, even as the volume of imported oil dropped by about 2%. The U.S. imported about $23.8 billion in petroleum and petroleum products in September, according to the Bureau of Economic Analysis report (.pdf file). That put a lot of money in the hands of Middle Eastern central banks and investors, who immediately put those dollars (remember, oil trades in dollars) to work earning interest by buying dollar denominated assets such as Treasury bonds.
The future is likely to bring major changes in direction to all three of the trends now driving the U.S. dollar higher against the euro and the yen. The shift is likely to be gradual. But by mid-2006 -- six to nine months from now, I think, is a reasonable time frame -- we're likely to see the dollar in at least modest decline against both the euro and the yen.
It's hard to imagine that, in a year, the political and economic chaos in Europe will be worse than it is now. For one thing, with the EU's four largest economies in one kind of crisis or another, the union has run out of economies big enough to get the financial world's knickers in a knot if they joined the parade down the road to perdition. No disrespect meant, but a crisis in Belgium or Portugal isn't going to alarm many on Wall Street.
Six months from now, the French government is likely to have muddled its way to some kind of reduction in violence, the failures of the German grand coalition will have gone from alarming headlines in the Frankfurter Allgemeine Zeitung to the butt of Berlin cabaret comics. Without the British prime minister in the hot seat, the French will be less interested in publicly humiliating the opposition.
And the interest-rate gap between the U.S. and the rest of the world is likely to narrow, or at least stop expanding. The Bank of Japan has started to pave the way for reversing course with predictions of rising economic growth and joyous proclamations of a return of barely measurable inflation. Sometime in 2006, the Federal Reserve will stop raising short-term interest rates -- the betting on Wall Street is on an end to interest rate hikes at 4.75% to 5.5%. The lower end of that range is just a December, January and March rate hike away. If the Fed stops raising rates, that will give euro and yen rates a chance to catch up -- or at least stop them from looking less competitive with each passing Fed meeting.
From U.S. homes to Saudi hands
The shifts in these two trends won't send the dollar into a tailspin unless the great U.S. real-estate ATM seriously flags in 2006. The global flow of dollars currently goes from real-estate-rich U.S. consumers, via gas pumps, to the portfolios of Middle East (and other oil-exporting) nations and then back into U.S. Treasurys.
But that's not a closed system. It requires the U.S. oil consumer to come up with a steady supply of new dollars to feed into the dollar pipeline. Since the Federal Reserve started pumping up real-estate prices to cushion the blow of the bursting of the stock market bubble in 2000, U.S. consumers have found those dollars by refinancing their mortgages or borrowing against the equity in their homes.
Home prices don't have to fall to reduce the flow of dollars from those sources: The regular flow of dollars from real estate to gas pump to the Treasury market has depended on a constant rise in real-estate prices. There's evidence now that price increases are starting to slow in many of the most overheated markets. That will mean fewer dollars for the pipeline and at some point a reduction in demand for U.S. Treasurys.
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