Has the dollar finally turned?

By Tom Stevenson, 14 August 2008

In this week’s column, Tom Stevenson investigates the US dollar’s remarkable return to form Ahead of my summer holiday in America, I’m unusually interested in the dollar/pound exchange rate. It’s not a pretty picture for a Brit flying west. The pound has fallen against the dollar for nine consecutive days. On 17 July a pound bought $2.01. Yesterday, it was worth just $1.88, a 21-month low¹. What’s going on? 

There are two ways of looking at cable (the familiar name for the pound-dollar trade that harks back to the early days of transatlantic communication). Exchange rates are relative measures, so the recent moves could either be a result of a strong dollar or a weak pound. This time it’s arguably a bit of both.

You don’t have to look far to see why the pound should be weakening. Bank of England governor Mervyn King shocked the market yesterday when he gave a broad hint that although inflation is poised to exceed 5%, the Bank is more worried about slowing growth and prepared to look through the inflation spike. He said that if interest rates stay at their current level of 5% then inflation will undershoot the Bank’s 2% inflation target within its two year forecast horizon². In other words, expect the next move in rates to be downwards.

King forecast that the British economy will grow by just 0.1% in the first quarter of 2009 compared with a previous forecast of around 1%. UK unemployment rose in July by the most since 1992 and wage growth slowed³. The housing market continues in freefall. Despite all these worrying signposts to recession, prices are rising at the fastest rate in 16 years⁴. No wonder the governor said that despite it being August, there’s “a chill in the economic air”.

So, one reason for the pound’s slump has been confirmation that the UK economy is experiencing a nasty bout of stagflation – rising prices but sluggish or even negative growth. Traders are betting that the next move in British interest rates will be down, which by itself would make the pound relatively less attractive to hold. Add in the prospect that inflation will reduce the purchasing power of sterling yet further and the stampede for the exit may look sensible.

The flip side of the Anglo-American currency cross is the health of the US economy and the desire of international investors to hold dollar-denominated assets.  Again, the key word is “relative” because the outlook for the American economy does not have to be great, just better than everyone else’s, for the dollar to benefit.

No-one would pretend that it’s a bed of roses on the other side of the Atlantic, with the financial sector under continuing stress and the housing market yet to find a floor. But having slashed rates more quickly than other central banks felt able to, the Fed has probably stopped the rot. It’s not in good shape, but the US economy is out-performing both battered expectations and beleaguered competitors. The story in almost every other major economy in the world is dire.

HSBC conducted a whistle-stop tour round some of the world’s key economies this week and found an unremittingly gloomy picture: declining GDP in Germany, New Zealand, Canada and Japan; banking problems in Switzerland; falling oil revenues in Norway⁵– the list goes on and on.

Now that commodity prices, especially oil, have come off the boil, central banks are no longer angling for a strong currency to keep inflation at bay. Quite the reverse. They are all looking for competitive devaluations to make their exports look more attractive on the global market. Meanwhile, Fed chairman Ben Bernanke has been talking up the dollar because he’s worried that a six-year slide in the world’s reserve currency (see the chart below) is stoking rising prices at home.

The reason the dollar’s bounce in the past couple of weeks is such a big deal is that it potentially reverses a massive one-way bet that has held good since the bursting of the American-led technology bubble. Anxiety about the US twin deficits (the shortfalls in the government’s budget and the country’s international trade) have driven the greenback relentlessly lower for years, but traders are now backing the theory that a major watershed has been reached.

Data from the futures markets showed that speculators flipped their positions on the dollar from short to long last week for the first time in 18 months⁶.

If the dollar has turned, what does it mean? The first point is that it makes dollar assets attractive to hold because they provide overseas investors with a currency kicker in addition to any other capital gains or income.

Another indirect conclusion to be drawn from the dollar’s strength is that the “decoupling” thesis, which said that the rest of the world could prosper even as America slumped, was probably overstated. That is probably not such good news for emerging market and European investments.

Finally, it suggests that the fall in the prices of dollar-denominated commodities like oil and gold are likely to continue. Knowing whether it is a rising dollar that causes falling oil and gold prices or the other way around is an age-old chicken and egg question. But either way the tide seems to have turned.

I’m going to enjoy my American break this summer, because the charts are telling me that I may not be so keen to go back next year.

Past performance is not a guide to what might happen in the future. Please note the value of investments can go down as well as up so you may get less than you invested. Investments in small and emerging markets can be more volatile than other developed markets and changes in currency exchange rates may affect the value of an investment. The ideas and conclusions in Tom Stevenson’s weekly column are his own and do not necessarily reflect the views of Fidelity’s portfolio managers. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.