The Stalwart Greenback

(Export Development Canada – Peter G. Hall)

‘Up’ isn’t a word that describes much in the American economy at the moment. Housing is down, the stock market is down, liquidity is down, and more recently, national output itself is down. And in a rapid reversal, even inflation is down. So why is the U.S. dollar currently on a big tear?

Times were great for the U.S. dollar in the 1990s. Large productivity gains powered the U.S. economy, and helped the currency rise 38% against all other currencies from 1995 to 2001. But things hit a snag in 2002. Slower U.S. growth and concerns about a trade balance headed further into the red checked the greenback’s ascent. It gave back about 18% of the appreciation over three years, and then held its ground. The depreciation restarted in mid-2006, and over 2 years shed an additional 13%. October’s rebound alone has regained the ground lost in that timeframe.

Will it last? The predominant view 6 months ago was that the U.S. economy’s woes would weigh against the greenback for the foreseeable future, and the hunt for a replacement reserve currency was on. Yet U.S. woes surprised many by going global. Add to that plunging commodity prices, financial markets turmoil and a global confidence meltdown, and suddenly greenbacks are all the rage. Uncertainty has yet again favoured the U.S. dollar. But is there more to today’s rally?

Current events have created special immediate needs for U.S. dollars. European banks’ USD asset base wilted in the wake of the sub-prime crisis, creating a wide gap between assets and the considerable USD deposits accumulated in recent years. Plugging this gap has required heavy purchases of dollars. In addition, firms the world over that bet against the USD in recent months are now having to purchase large amounts of dollars to close out those positions.

These transactions are significant, but will run their course in short order. Can we expect the dollar to slide in the aftermath? Perhaps, but any slide is likely to be small, and short-lived. Why? The global slowdown will persist well into 2009, and there is still a lot of negative news to digest before this one’s over. The recent flight to quality that has favoured the USD still has legs.

There are key fundamental reasons that make the USD a good long term play. Much is said about the sorry state of U.S. public finances, but U.S. government gross liabilities were only 63% of GDP in 2007, well below the 75% OECD average. Factor in the huge recent commitments to the financial sector, and US public liabilities will likely still remain below the OECD average.

Dollar critics have also pointed to the gaping U.S. trade deficit as a negative influence. True, the deficit swelled to over 6% of GDP by late 2005. But recent dollar depreciation reduced the deficit to 5% of GDP, and high oil prices masked even more significant progress. The non-oil deficit sunk to just over 2% of GDP in the second quarter, a level last seen in early 1999. With oil prices down 55% since July, the trade deficit could well approach a sustainable 3% of GDP by year-end.

The bottom line? Global economic malaise is boosting the greenback, and current confidence in the dollar is anchored in strong or improving fundamental supports. And given that the U.S. is likely lead the world economy back to growth, mild near-term dollar appreciation is a good bet.