I am somewhat surprised by the lack of vigor in the markets these past few trading sessions and by the weakening U.S. dollar. While I have long been cautious, I had expected performance anxiety to kick in and the market to shoot higher. Like everyone else, I am curious as to what the last few weeks of 2006 bring and how the markets in early 2007 behave.
There are two good articles on the U.S. dollar, both of which are worth your effort to read in full. The first article is from The New York Times Dollar Falls Sharply Against Euro and Pound (registration required).
And the second article is from the Financial Times Markets rocked by sharp slide in dollar (subscription might be required).The dollar dropped sharply yesterday against a range of major currencies, with the euro breaking through $1.30 for the first time in a year and a half. The fall highlighted concerns about softness in the American economy as economies abroad continue to expand.
The currency sell-off came as investors weighed a number of issues that complicate the prospects of the United States in the coming months, including a huge trade imbalance with China and a slowing domestic housing market. On top of that, economic growth in some European countries is gaining momentum, threatening to siphon investment away from the dollar.
The dollar’s losses came in a thin trading day in which the British pound rose to its strongest value against the dollar in two years. The euro traded at $1.3079 yesterday afternoon, up from $1.2941 on Thursday. The pound was trading at $1.9317, up from $1.9156.
The dollar has now fallen this year by more than 10 per cent against the euro and 12 per cent against sterling. Some economists suggest the greenback has further to slide given a weak economic outlook in the US, and the prospect of interest rate cuts there next year.
Steve Saywell, currencies analyst at Citigroup, said: “While the economic data remain soft, the dollar will continue to fall.”
The gaping US trade deficit, the near certainty of a December rise in eurozone interest rates, rising expectations of a cut in US rates in the spring and wariness about borrowing in yen to finance investments in the US all continued to weigh on the dollar, analysts said.
The challenge is that for many key factors, they do not matter until they do, and then they are the only things that matter. Does the dollar come under more pressure? Will foreigners purchase other currencies or precious metals to replace the dollar? Are the problems that many investors have talked about—such as high energy costs, high inflation, softening home prices, and possible adverse tax changes—finally beginning to affect the consumer?
Just as some investors are concerned with the prior problems, other investors point to low unemployment and a reasonably robust economy. While they acknowledge there are challenges, they believe that the strength of the economy is simply too strong.
The problem in trying to answer the prior questions is that you never know until after the fact. It is extremely hard to gauge when change will occur. Sometimes, oftentimes, a trend is sustained for far longer than most expect. As an investor, I try to identify possible influences and then monitor. I also make sure that my portfolio is diversified.
I will be watching carefully to see how the markets and the U.S. dollar react in the weeks ahead.
The big question is why is the trade imbalance growing? When a currency weakens, it usually makes exports of that country more attractive and financial services (which is where the trade imbalance goes) less attractive. In my opinion, the answer is that China's currency is undervalued and since they are a substantial trading partner, their currency is lowering the value of the dollar. This is actually good for us as their action keeps interest rates low and provides us with actual goods. The problem comes in the future when they stop providing a devalued exchange rate. In actuality, the US government is inflating the money supply to "tax" China and other large currency holders.
The improvement in the Euro and the Pound is mostly due to cheaper oil. The Europeans are more dependent on foreign oil than we are and cheaper gas spells more economic expansion. This is all short term. With Russia looming on the horizon, the Europeans sure look to me to have more instability in the future.
Jeff, you raise a lot of good points.
I am not sure that weakened currency makes the exports more attractive and imports less attractive. Yes, that is classical economics. But I think currencies are driven a lot by momentum. Once the train begins moving, it keeps moving for a while regardless of the actual fundamentals at play.
And although China's currency is undervalued, I do not believe it would make much difference to the U.S. situation if China were to raise its currency by 20% to 30%. In fact, it might actually make matters worse because imports might become simply more expensive. I doubt that the negative trade balance growth would slow. At best, it might partially relocate to some other Asian country.
China is in a difficult position. It needs to create jobs for those coming to the cities. And it must do something with all the U.S. dollars it is receiving.
I agree with your assessment of Europe. They depend heavily on Russia for their oil and gas. Much to Europe's chagrin, Russia does not seem to intent on following the western model of free enterprise where individual companies compete. Instead, Russia the country appears to be using its vast natural resources to extract maximum economic value and geopolitical gain. The unfortunate reality for Europeans is that they have little choice but to pay up in the short term. Longer term, they need to find an alternate supply or fuel.
Just as China is in a difficult position, so is Russia. Its population is declining. Heath concerns, if you believe western reports, are increasing. Its population is aging. Russia too knows that in 50-75 years, its oil and gas will largely be gone. It has very few noncommodity competitive industries. Most of the country in eastern Siberia is uninhabited. The Chinese are crowded in their country and are looking over the border to all the free and open space. How does Russia prepare itself for the future?
This is certainly an interesting time.
Thank you for your comment Jeff.