Worries Over The Dollar Are Likely To Fade
Any degree of stability in dollar/yen will likely spur markets to revert back to their respective trends
Written by Tony Crescenzi , CEO BondTalk.com
Sept.,22, 2003
In what is likely to be a short-lived event, the financial markets have been roiled by indications that the Group of Seven nations (G-7) would like to see the dollar weaken against Asian currencies, particularly the Japanese yen and the Chinese yuan. The worry in the financial markets relates more to concerns over how the dollar’s weakness will affect international capital flows than to its potential effects on the U.S. economy. Big budget and trade deficits are at the root of these worries.
But as with previous episodes where the dollar weakened, investors are likely to ignore the dollar’s weakness the moment the dollar’s decline either stops or slows. The fact is, so long as the dollar’s decline is orderly, it is good for U.S. corporate profits, good for the U.S. economy, and it provides a better entry point for foreign investors to buy dollar assets.
The dollar’s decline will only help the U.S. to bolster its position as the strongest industrialized economy in the world, helping it to remain the preeminent place to invest in and trade with.
G-7 Signaled Desire for “Flexible Exchange Rates” Last Week
Even before this weekend’s G-7 meeting in Dubai, there was a growing sense that the G-7 might signal a desire to see the dollar weaken against the yen and the yuan. G-7 participants had signaled as much throughout last week, going so far as to leak key elements of the communiqué that were expected to be issued at the meeting. In response, the dollar weakened sharply against the yen throughout the week, with the exchange rate falling to 114 yen per dollar from 117.3 a week earlier. The break below 115.0 in dollar/yen was particularly important, as it was a key support level for over two years, breaking a so-called neckline in an apparent head-and-shoulder formation (a bearish development).
Although there were obvious signals about what the G-7 might say at the conclusion of its meeting, U.S. markets didn’t respond much, as both stocks and bonds behaved well. This is one sign of what likely lies ahead: investors aren’t too worried about a weaker dollar. They only worry when the dollar’s decline is rapid and disorderly. Proof of this is the behavior of stocks and bonds since the dollar began to fall sharply against the European euro beginning at the start of 2002. It is notable, for example, that when the dollar fell about 10% against the euro earlier this year in March through May, U.S. stocks soared nonetheless.
History Overwhelmingly Suggests Calm
One of the most important episodes of the past ten years that helps shed light on the type of response that could be expected in U.S. markets occurred in 1995. From February to April of that year, the dollar plunged about 20% against the Japanese yen, falling to a post World War II low of 80.63 on April 18th. The situation was partly the result of confusion about the Clinton administration’s policies toward the dollar. Confusion had developed in 1994 when comments from Treasury Secretary Lloyd Bentson were interpreted as ambiguous, resulting in a weakening of the dollar.
Throughout that 1995 episode, there was a palatable sense of anxiety and uncertainty about what might happen next. Nevertheless, equities and Treasuries marched steadily upward. The important point here is this: the anxieties in the financial markets are likely to be momentary blips that won’t get etched onto long-term charts. In other words, the concerns will tend to be manifested in concerns that last hours or day, not weeks or months.
Foreign Investment in the U.S.
The root of investors’ worries about the dollar is the current level of the U.S. budget and trade deficits, now at about $400 billion and $500 billion each, respectively. These large deficits increase the need for foreign investment in the U.S., without which stock and bond prices would likely be lower.
Concerns about foreign money held in U.S. equities are likely overblown. It is notable, for example, that foreign investors have not invested much in U.S. equities over the past two years, with net purchases totaling just $22 billion over the past year. Moreover, foreign holdings of U.S. equities represent only around 10% of the total value of the stock market. Perhaps the biggest reason to believe that concerns are overblown relates to the impact that a weaker dollar will have on corporate profits. Profits are likely to increase not only because of a likely increase in U.S. exports, but because U.S. companies operating abroad will convert the foreign currencies that they earn back into U.S. dollars. In addition, U.S. companies will have added pricing power as a result of a rise in import prices. With sales and profits up, and pricing power improved, companies are more likely to increase their capital spending, providing further stimulus to the U.S. economy.
A bigger concern than the dollar’s effect on stocks should be its potential impact on bonds. A weaker dollar could boost the economy and hence worry bond investors, who tend to loathe strong economic growth. In addition, the bond market might worry that foreign investors will reduce their investments in the U.S. bond market, where foreign investors have a much greater presence than in the stock market. These concerns are rooted in the fact that over the psat few years, foreign investors have been big net buyers of U.S. bonds, buying over $600 billion of U.S. corporate, agency, and Treasury securities just over the past twelve months. Moreover, foreign investors hold close to 40% of all U.S. Treasuries outstanding.
Foreign Investors Not Likely to Flee; U.S. Still Attractive Place to Invest
With the U.S. budget deficit large and growing, who will give money to Uncle Sam? That is the thinking. But this thinking ignores the fact that the U.S. dollar is the reserve currency of choice throughout the world, and that there’s a natural demand for Treasuries created partly by the dollars foreign countries generate from their trade surpluses with the U.S. Foreign investment in U.S. bonds is likely to remain high also because the U.S. bond market is the largest and most liquid in the world. Increased corporate profits can’t hurt, either.
An important factor working against extensive weakening in the dollar against Asian currencies is the fact that the G-7 statement contains no enforcement mechanism nor does it indicate that the policies that have artificially boosted the dollar against the Asian currencies have been changed. In particular, China’s policy of fixing its exchange rate to the U.S. dollar remains in place, and Japan remains likely to intervene to support the dollar, albeit at a lower level (of dollar/yen) than before. In addition, the relative growth story still favors the United States, especially in light of favorable tax and regulations policies in the U.S. relative to much of the industrialized world, particularly in Europe and Japan. This means that the rates of return on investments in the U.S. are likely to remain very attractive.
The doomsayers will be out in droves this week, claiming that the dollar’s decline is a manifestation of the U.S. budget and trade deficits and that the weakening dollar will suddenly spur foreign investors to flee the U.S. The same was said by many in 1995 and before that in the mid-1980s when the dollar began a 10-year decline that cut its value in half versus most currencies. That period was one of the most prosperous in U.S. economic history, a period when the value of the Standard and Poor’s 500 tripled in value. |
