Monday November 14, 2005 - 11:28:01 GMT
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Forex: How long can the US dollar ignore the trade deficit?Economics Weekly: How long can the US dollar ignore the trade deficit?
Record US trade deficit, yet a stronger dollar!
The parlous state of the US trade deficit should not pass without comment in a month that it reached yet another record level. It is perhaps easy to forget that a year ago the US trade deficit was $51.9bn per month. The year before that it was $41.6bn and in September 2002 it was just $36.8bn a month. Now, it is running at $66bn a month, an 80% increase on 2002, and yet this year the currency seems to be shrugging it off, see chart A. What is going on?
Currencies are influenced by many factors
There are a large number of factors that influence exchange rates. Many are well known, ranging from inflation, interest rates (short and long term), economic growth, trade and current account balances, fiscal deficits and equity market flows. Others are perhaps less well known, such as political risks, exchange rate intervention, commodity prices, risk aversion and productivity differences, to name a few.
US trade deficit is being ignored...
At any particular moment either one or other of these may be the key determinant of the exchange rate of a particular currency. In a survey conducted by Consensus Economics in August 2005, 250 foreign exchange rate forecasters were asked to rank in importance the factors they judged to be affecting the exchange rate of a number of currencies against the US dollar. Table 1 shows responses for the factors voted to be the key drivers of the dollar against euro, sterling, Japanese yen and Canadian dollar. It can be seen that the highest ranking factor at the time, on average, is differences in short term interest rates. This is closely followed by differences in trade balances and investment flows, driven by differences in long term interest rates and by equity market flows.
Fiscal deficits can matter greatly for a currency, but budget deficits are worsening in all of the major economies and so they have not played a big role in the rankings shown in table 1.
However, this may also be because the bond yield differential may be picking up perceptions about the relative state of fiscal positions. As chart B confirms, an important part of the current profile of dollar strength seems to be that interest rates are rising faster in the US than in any of the other major economies at present. This is true not just of short term interest rates, but also of longer term interest rates, including ten year bond yields. This is giving a higher return to foreign holders of US assets at current exchange rates and as such will remain a powerful underpinning of the US exchange rate as long as it persists and markets are driven more by it than any other factor.
Growth and interest rates are key drivers...
In order to help assess the factors underlying the strength of the US dollar, we look at the UK’s performance on three key measures as a proxy, interest rates (long and short) and economic growth. The charts, B and C, show that although the direction of the US trade deficit suggests that the currency should fall, interest rate and growth are powerful enough factors together to offset the negative impact of the trade deficit. That, in a nutshell, seems to be the story. However, this does not mean that the dollar will not weaken at all. It is actually very vulnerable to any deterioration in the factors that are underlying its relatively strong performance.
..but attention will switch back to the trade balance at some stage
In particular, the US $ appears very vulnerable to whenever US interest rates stop rising or interest rates increase in other countries. As chart A shows, over time, the dollar does actually respond to the trade deficit. This current period is actually the odd one out, due, as table 1 highlights, to the sharp rise in interest rates and the growth outperformance of the US economy at present. Hence, it appears the challenge for forecasters is in calling the end of the dollar run correctly; a cessation of interest rate hikes or weaker economic growth in the US may have to be the essential triggers for any sustained dollar weakness.
What underlies the fast growth of the US? The real answer appears to be that US productivity is outstripping that of the rest of the world’s other major economies. As long as that continues, then it is possible for the US to avoid a currency crisis, but that does not mean the currency will not depreciate, just that it should not collapse. The question for financial markets as we approach 2006 is, when will the dollar correct? The question for policy makers is, will it be to the detriment of the world economy?
UK data this week may be overshadowed by the bank of England's quarterly Inflation Report, which will be scrutinised for clues about the next move in interest rates. Figures out in the week may be contradictory. Producer price inflation on Monday could show a fall back, as oil prices recede from their highs. Consumer price inflation, on Tuesday, could also show a fall back from September's figures, though that will not mean that the threat from earlier increases in input prices is over. Inflation on our forecast remains at 2.5% in the year, still well above the 2% target. Data for the labour market, on Wednesday, are likely to show that wage inflation is still subdued at 4.2% and unemployment on the claimant count may rise for a ninth month in succession. Moreover, retail sales, which bounced by 0.7% in September, could fall back in October, though that is not our central forecast. On Friday, attention will be on the borrowing data; is slow growth hitting government tax revenue or is the rise in oil company profits offsetting it? Fast growth in M4, the broad measure of money, is likely to continue, suggesting that economic recovery can be easily financed.
Trevor Williams, Chief Economist
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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