During the past two years, the dollar has stubbornly refused to cooperate with consensus views on its future. The smart money, awed by America's huge $218.4 billion current-account deficit, predicted that the dollar would fall by 20 percent, even 40 percent or more against major currencies. In forecasting a dollar crash last June, financier, George Soros said, “The international financial system is coming apart at the seams.” Investment legend Warren Buffett reportedly shorted the dollar in January 2005 — to the tune of $20 billion.
But guess what? The greenback has actually appreciated since the dire predictions were cast. As a result, dollar bears — those who have bet against the dollar by, say, buying shares in foreign companies — have only turned a profit because the foreign markets themselves rose more than the relevant currencies lost to the dollar. So far, their underlying assumptions about the strength of the dollar have proved wrong. Still, many economists continue to forecast sharp losses in the value of the dollar and investors should take note.
Currency values are notoriously volatile, and the last few years have offered no exception to that rule. The dollar was riding high at the beginning of this decade, rising by 30 percent against the euro and 31 percent against the yen between 2000 and 2002. (See table.) Remarkably, that rally occurred despite the nation's foreign trade deficit, the stock-market crash, the recession in the U.S. and the shock of the Sept. 11 attacks. But by 2003 and 2004, that large and growing current-account deficit (the broadest measure of trade in goods, services and investment flows) began to hurt the greenback. By the end of 2004, the dollar had fallen 60 percent from its 2002 highs against the euro and 25 percent against the yen.
Then, in 2005, currencies did an about-face. The dollar began to rise, even though America's current-account deficit deepened to record levels (it's now hovering at about 6.6 percent of GDP). In 2005, the greenback gained 11 percent against the euro and 15 percent against the yen. So far this year, the dollar has lost a little ground, but is still 7 percent above its 2004 lows versus the euro and almost 16 percent above its lows against the yen.
Money Grows
Why isn't the huge current-account deficit tanking the dollar? For one, China is intent on keeping the yuan undervalued. To pursue that policy, that basically forces the People's Bank of China to buy U.S. Treasuries and other dollar-based assets. Japan, concerned over China's rise as an economic competitor, has also been selling yen and buying dollars. Europe, dependent on exports, has been selling euros to keep the currency from growing too strong. Besides the economic rivalries, there is one other very fundamental factor: The American economy is stronger than the rest of the developed world, and that keeps investment funds flowing into the States.
The result: The supply of euros and yen on world markets has far outstripped the supply of dollars. In the U.S., M1 (a narrow definition of money supply) has expanded by a negligible 0.6 percent over the past 24 months. Meanwhile, the European Central Bank (ECB) reports that the Eurozone's money supply has increased by 25 percent; in Japan, the money supply grew at an 8.4 percent rate. Broader-based money figures tell a similar story, as do composite measures of currency and reserves, which, in the U.S., is referred to as the monetary base.
This has been going on for years. Since 2001, the Bank of Japan and the ECB have been much more generous with money creation than the Fed has. Between 2001 and 2004, the euro-based money supply rose by 33 percent and the yen-based money supply by 46 percent. The dollar-based money supply during that same period rose by only 14 percent. Since 2004, the Fed has taken advantage of the healthy U.S. economic expansion to raise interest rates and drain any excess liquidity from the financial system, actually shrinking the U.S. money supply marginally. Meanwhile, the ECB has continued its rapid monetary expansion, increasing the Eurozone's money supply by an additional 23 percent. The Bank of Japan seems to have begun to gain control, slowing yen-based money growth to around 5 percent, but that's still faster than the Fed's allowing.
On a Monetary Diet
The ECB and the Bank of Japan say they want to correct the situation. And they have time to do so and avoid the worst economic effects. Inflation is lower in Europe than in the U.S.; in Japan, many price measures still indicate deflation. But should either central bank move too quickly to restrain money and liquidity growth, it would raise a significant risk of recession, which, of course, would demand a major strategy adjustment toward dollar bonds and away from commodities and equities. Though this kind of precipitous policy shift is not likely, the risk presents yet another reason to favor the dollar.
The prognosis: Currency markets certainly will penalize the euro and the yen. But it's hard to see much of a dollar rally given America's astronomical current-account deficit. It also means those who have skewed their client portfolios on the basis of a weaker dollar should take heed. Maybe, a heavy exposure to foreign stocks or bonds needs reconsideration. The other point being that you should only invest where market prospects themselves look good and not to minimize dollar assets.
Similarly, investors might do well to rethink any currency-based distortion in their domestic equity strategy, such as buying securities of companies with extensive foreign exposures. And, obviously, those who have made a pure bear bet against the dollar by shorting it — with, say, an inverse dollar ETF or on futures or forward markets — might do well to cover their positions, if they haven't already.
Milton Ezrati is a partner and senior economist and strategist at Lord Abbett.
