Why the Dollar Can Be Strong by Gary Scott

Recently an astute reader asked me this question.

“Gary, I am really curious why the US$ has been so strong for the last year. Any hint? Sincerely, Rudy”

We may all profit from the research that went into my reply to Rudy.

First keep in mind that though the dollar has been strong, it is falling now. At least in the short term. The January 7 Economist, says:

“The dollar suffered its biggest two-day drop against the euro in two years, hitting a two-month low of $1.21 against the European currency on January 4th. The dollar stumbled after the release of the minutes of the December meeting of the Federal Open Market Committee, which signalled that interest-rate rises may be nearing an end.”

The yen is also appreciating rapidly right now and of course gold is sky rocketing.

But we should not speculate on a dollar collapse without caution. Let’s look at some statistics and see all the pressures that might push the dollar down and up.

First on the downside America’s trade deficit has been pushing down on the greenback for many years.
The huge negative current account deficit is at 6.5% of Gross Domestic Product (GDP) and this also places downwards pressure on the buck. Europe has a small current account surplus of 0.1% of GDP and Japan’s surplus is very high at 3.3% of GDP.

Stock market moves in 2005 also favored Europe and Japan over the US. Europe ‘s exchanges were up 9.7% overall. Japan’s market was up 25.5% versus a 5.1% rise in the S&P and 4% NASDAQ growth. But right now Wall Street looks strong at a time when it is traditionally weal.

Yet there are are plenty of reasons for the dollar to have some strength at this time.

First keep in mind the strength of its rebound. If we take a longer view, the dollar has fallen seriously versus the euro. Sure its up from its bottom back about a year and a half, but it is nowhere near the parity it was few years ago. Part of correction now may just be a bounce back.

Plus most countries want a strong dollar and many support the buck by buying it. They want their products to remain cheap in America. US spending has stimulated the global economy and no one wants this to change, except American firms that export. So speculators have to beware of government intervention.

Asian and other nations are also buying US businesses and or investing in new plants in the US. This attracts money to America and increase demand for the dollar.

In addition America is not the only economically mismanaged nation. The US budget deficit, as bad as it is at 3.7% of GDP, is not that much worse than Europe’s (-2.9%) and the US deficit is much better than Japan’s horrible –6.5% of GDP.

Europe’s overall debt (if we can believe the statistics) is 71.3% of GDP, about the same as in the US. Japan’s debt is seriously worse at a whopping 144% of GDP, double that of the US!

US unemployment figures look pretty good at 4.9% of the work force versus 4.6% in Japan and 8.8% in Europe.

Japan and Europe also share America’s aging problem,

I suspect that the greatest US dollar strength has come from interest rate differentials. 3 month dollar CD rates rose to 4.22% up from 2.54% in the last year. Euro CDs only pay 2.49% and the yen rate is basically zero. Bond rates in dollars were also much higher, 4.36% for ten year bonds compared to 3.29% in euro and 1.52% in yen.

For the year ahead watch the stock markets and interest rates.  PLus the price of gold. My guess (and predicting currencies is always a guess) is that currencies with the highest interest yields and hottest stock markets will be the ones that will see the greatest strength. Plus the dollar yen and euro will weaken versus gold.

Until next message I hope your global investing sees great strength as well.

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Gary is a guest author here at the SelfInvestors blog and provides a look into investing trends, specifically in world markets.  If you’d like to sign up for his daily newsletter or one of several seminars throughout the year in Ecuador and North Carolina, you can get all the info at this personal site.

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I thought I’d throw up a couple charts of the US Dollar Index to give another perspective on where the dollar is headed.

First the long term 15 yr view which shows very strong support at 80.  Notice the severity of the decline in the dollar from ’02 to ’05.  While the dollar recovered significantly in ’05, that kind of drop typically needs a considerable amount of time to recover from, indicating the dollar could bounce around the 80-90 level for quite some time.. perhaps another year or two.  That’s assuming that it will hold up above 80.  Of course, a drop below 80 for another leg down is a possibility, but support is very strong there so it isn’t likely.

Lets look at the shorter term view.  The year long uptrend that began in early ’05 is clearly breaking down indicating further weakness ahead for the dollar.. at least in the short term.  You can see how the support line of the uptrend is now acting as resistance.  Furthermore, support of the 200 day moving average has been taken out as well.  Possible support areas to watch: 87.50, 85 and 80. If I were to make I prediction I’d say that the dollar retests support at 80 sometime over the next 12 – 18 months before heading higher.