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Tracking the Dollar's Fall

In the past two years, the dollar has remained remarkably buoyant even though the U.S. has suffered a recession, the New Economy has lost much of its luster, equity markets have soured, and accounting scandals have rocked the business community.

Yet many experts say the dollar can't stay strong much longer. America's net foreign debt has reached a quarter of gross domestic product, and the current-account deficit hit 5% of GDP last quarter (chart)--both the highest levels since at least the Civil War. The current-account figure covers both trade and flows of investment income.

The main question is whether the dollar's fall will be orderly or chaotic. In its latest world economic outlook, the International Monetary Fund warns that continuing imbalances in the U.S. and global economies could spark "an abrupt and disruptive adjustment of major exchange rates." According to economist Stephen S. Roach of Morgan Stanley, the odds still favor a gradual dollar decline lasting several years, assuming the adjustment begins relatively soon.

Even an "orderly" adjustment would cause considerable pain. In a recent econometric study, Martin Neil Baily of the Institute for International Economics projected the consequences of the scenario he feels is most likely to unfold: a 20% to 25% decline in the dollar's inflation-adjusted exchange rate over five to six years. He finds that with such a drop, real GDP growth over this period would be pared by 0.25 percentage points and annual growth in consumption and investment would be lowered by 1 percentage point and 2 percentage points, respectively. In addition, the inflation rate during the adjustment would be boosted by an average 1 percentage point, and the federal funds rate could rise as high as 8% before receding.

Of course, the pains would ultimately produce substantial gains--among them revitalized U.S. exports, less U.S. dependence on foreign investors, and, crucially, less foreign dependence on U.S. demand. Since 1995, notes Roach, the U.S. has been virtually the sole engine of global growth, accounting for 64% of the increase in global GDP.

And if the high-flying greenback refuses to weaken? The longer it stays at today's lofty levels, says Roach, the greater chances of an abrupt dollar collapse, which could precipitate double-dip recessions in the U.S. and Europe. The average economist dismisses the use of so-called technical analysis to predict financial markets as hooey. Technical analysts--also known as chartists--try to figure out whether prices will go up or down by looking at patterns in graphs of recent prices. Most economists say investors would be better off assessing the fundamentals.

But in the currency markets, technical analysis actually seems to work, according to a new study by Carol Osler, an associate professor at Brandeis University who used to be an economist at the Federal Reserve Bank of New York. Osler offers a two-part explanation: First, predicting prices from fundamental factors is even harder to do in the case of currencies than in the case of stocks, as the surprising strength of the dollar shows. Second, because fundamentals are of so little help, currency traders usually base their buying and selling decisions on purely technical factors, such as whether a currency has broken through some significant price level. Osler says that technical analysts who successfully account for traders' behavior can make good money.

One key pattern in currency trading is the tendency for trades to cluster near round numbers. That's because traders often enter orders to buy or sell currencies when they hit certain specified levels. These levels are usually numbers ending in 0 or 5. As a result, currencies have a greater likelihood of peaking or hitting bottom at those levels. What's the magic of round numbers? "It's easier to do the math," says Osler. With housing markets booming, consumer mortgage debt has soared almost 70% since 1995, according to the Federal Reserve. The share of disposable income going to pay mortgage debt has risen, too. Many economists worry that this debt burden will crimp consumer spending, which has given the recovery what little momentum it has.

However, the burden of mortgage debt isn't as heavy as it seems, according to a study by William C. Natcher, an economist at National City Corp., a Cleveland-based bank. Natcher observes that a rising percentage of Americans own their homes. As people switch from paying rent to paying a mortgage, that increases the national-debt burden automatically and boosts the overall amount being paid on mortgages.

Yet people who buy a home for the first time are spared paying rent. Once you account for the fact that more people own homes, the average share of household income dedicated to mortgage payments this year is almost exactly the same as it was in 1995, says Natcher (chart). The current adjusted level of 5.94% is well below the peak of the last 15 years--6.5% in 1991.

Similarly, Natcher believes concern over swelling credit-card debt is exaggerated because credit cards have increasingly replaced cash as the most convenient way to pay for things. Many people who pay their cards off in full each month nevertheless show big balances on their cards during the month, and that's partly what shows up in the aggregate data.

Overall, says Natcher, "Rising debt is an issue, but it's not as big as everyone thought.... We think the consumer has some lasting power."

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