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The Drop of the Dollar: 2004 Trend Down

The trend of the dollar is straight down:

A fundamental view of the dollar drop from the article, “How low might the dollar sink?”, by The Economist:

As the dollar hit another new low against the euro, briefly breaching $1.30 on November 10th, an increasing number of economists are asking how far the greenback might fall and how its slide will affect the world economy. One of the most alarming answers comes from Paul Volcker, Alan Greenspan’s immediate predecessor as chairman of the Federal Reserve. He recently said that he thought there was a 75% chance of a currency crisis in the United States within five years. It is easy to see how this might happen. America’s current-account deficit is running at a record 6% of GDP this year, and on existing policies it will continue to widen. America’s net foreign liabilities are already 23% of GDP, and economists at Goldman Sachs calculate that this figure will reach more than 60% by 2020, even if the current-account deficit stabilizes at 5% of GDP (see chart). Other countries, such as Australia and New Zealand, have sustained large external deficits for long periods, but America’s borrowing is much bigger in absolute terms. It is eating up around 75% of the excess saving of Japan, China, Germany and other countries with current-account surpluses. If the dollar did not have the advantage of being the world’s main reserve currency, America would already be in serious trouble. Instead, the willingness of Asian central banks to lend to the United States has allowed its deficit to keep growing for longer. Nevertheless, the deficit is unsustainable: sooner or later it will need to shrink, and that will involve a cheaper dollar. A new paper by Maurice Obstfeld, an economist at the University of California, Berkeley, and Kenneth Rogoff, of Harvard, a former head of research at the International Monetary Fund, predicts that the dollar will fall by another 20% in real trade-weighted terms even if America’s external deficit unwinds gradually. If the adjustment is more abrupt, the dollar will dive by more than 40%. The real question is not whether the dollar needs to fall, but how drastic the economic effects of its fall will be. In the mid-1980s, the greenback’s trade-weighted value declined by 40% with few ill-effects in America. The world economy absorbed the shock reasonably well. Unfortunately, the authors see more parallels today with the dollar’s collapse in the 1970s, when the Bretton Woods system broke down. Like today, that was a time of large budget deficits, loose monetary policy and rising oil prices, and America faced open-ended costs to pay for a war. Today, the combined costs of fighting in Iraq and maintaining security at home could easily match the cumulative 12% of GDP that the Vietnam war cost. There is therefore a risk that the global economic consequences might be as severe as those which followed the demise of Bretton Woods, with higher interest rates and a drop in global output. If Mr Obstfeld’s and Mr Rogoff’s gloomier prediction turns out to be correct and the dollar falls by 40% or more, then this would, in effect, amount to the biggest “default” in history. This would not, of course, be a conventional failure to service debt, but could be viewed as default by stealth. America borrows from others largely in its own currency, so by letting the dollar drop it would wipe trillions off the value of foreigners’ dollar assets. In such circumstances, the risk of a financial crisis is not negligible. As Mr Rogoff puts it: “The world is set to jump off the top of a waterfall without knowing how deep the water is below.”

Trend followers don’t profess to be economists. Six months from now we all may find out these fundamental projections were either right or wrong. Either way, though, you need a plan to deal with the actual price movement. Projections and forecasts don’t make for good trading decisions. If the dollar stays down, trend followers will be short. At some point if the dollar reverses, trend followers will be long. If the dollar goes into a flat sideways period of starts and stops (false breakouts), trend followers will have many small losses. Bottom line the economic projections may happen or may not, but they don’t really help you to take action.

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