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That’s a billion dollar question. Let’s analyze the signals and economic environment in a comparative global context to see if the dollar trough is here or if there is room for it to depreciate further. Amongst other factors, the value of a currency is determined by the demand for the currency. Following are some of the key underlying factors which impact the demand and value of the dollar. A close review of these factors can provide some insight into the future value of the dollar.

  • The US housing bust
  • Interest rates
  • Foreign investments into US treasuries
  • US current account deficit
  • Dollar as a world reserve currency

The housing bust

The US housing bust seems to have triggered the current recessionary state of the US economy. Though the direct exposure of the GDP to housing may be limited to 5%, this time around the risk seems to have been spread much wider. The risk had actually been spread with the objective of de-risking; however, it seems to have wreaked much havoc with the economy.

The exotic loans that were offered, allowed buyers to pay minimal amounts in the initial years and the payments were to move up after this initial period in accordance with the prevailing interest rates. We all know that interest rates shot up and prices collapsed. Home owners found themselves in a position termed as ‘upside down’, where the outstanding loans were greater than the re-sale value of the home. At the same time, recessionary tendencies are leading to rising unemployment and inflation is leaving less disposable income in the hands of the consumers. This can lead to a situation of mass foreclosures and leave lenders with a stock of homes, which are lower in value than the outstanding loans. Estimates by experts suggest that the bundling of home-mortgage loans into other instruments has increased the exposure of this sector close to 40% of the economy. Thus, mass foreclosures could have grave repercussions on the US economy and a large number of players in the financial sector could be forced into bankruptcy. Such a collapse could immediately push the US economy into deep recession, forcing the Fed to cut interest rates further. We all know that the dollar could be hit further if such a scenario were to unfold.

 Interest rates, US treasuries and the current account deficit
 
The US current-account deficit has reached a staggering $1 trillion a year. A huge current account deficit implies that the demand for imports is greater than the exports. This means that the demand for foreign currency is greater than the domestic currency, which should lead to depreciation in the dollar. However, the US has run huge current account deficits for the past several years and maintained a strong dollar at the same time. The US has managed to do this by attracting nearly $60 to 70 billion monthly capital inflows via investments in to US treasuries. Nations such as Japan, Middle Eastern countries, and China traditionally have ploughed back their earnings from exports to the US and elsewhere into US government treasuries. This had set up a virtuous cycle, where the huge US current account deficit was financed by capital inflows and had become sustainable. However, now with the US having cut interest rates sharply, investments in US treasuries may not be attractive enough for these other nations. If these nations were to stop investing in US treasuries, the demand for the US dollar may decline considerably and lead to a further depreciation in the dollar.

Dollar as a world reserve currency

The American dollar has for long enjoyed the position of the world’s reserve currency. A majority of the world’s central banks hold vast dollar reserves to provide a backing to their currencies. Rough estimates put other central bank dollar holdings at about 70%, with the balance being held in Euros or other currencies. At the same time a majority of international trade has been dollar denominated. This includes pricing in dollar terms for commodities, oil, metals and a majority of other goods and services. The recent rapid depreciation in the dollar implies that the value of reserves held by central banks has dwindled. At the same time a weaker dollar means that returns on exports are on the fall. Earlier, there was no concrete alternative to the dollar as a reserve currency. But with the advent of the Euro, which is backed by an economy nearly as large as the US economy, the dollar has faced considerable challenge. A rapidly falling dollar could trigger greater usage of the Euro as a reserve currency. If central banks were to reduce their US dollar holding by a mere 5%, a massive sale of dollars could lead to a further depreciation in the currency.

 

Implications for the forex trader

Forex traders need to carefully evaluate the parameters like interest rates, the housing bubble and the status of the dollar as a reserve currency, before taking a position on the dollar. It appears that the dollar is fairly low in value at this time, but the worst may not be over as yet. The outcome of the Fed meeting scheduled for late April 2008 is also likely to announce one final rate cut. After this cut, it may be difficult for the Fed to cut rates further due to the inflationary tendency in the economy.