By Michael Wallace Here's a "wall of worry" for investors: the significant drop in the value of the U.S. dollar in recent days. The fall could be tied to an array of unsettling factors, including the Treasury Dept.'s survey showing a September plunge in U.S. asset holdings by foreign accounts, fear of rising trade protectionism after the Commerce Dept. announced import growth quotas on Chinese textiles (see BW Online, 11/19/03, "Bush's Threadbare Chinese Quotas"), and a rise in global terrorist activity as President Bush visited Britain. Add in the various U.S. financial-market scandals, including the ongoing mutual-fund investigations and the alleged involvement of U.S. banks in helping housing agency Freddie Mac allegedly "smooth" earnings figures.
However, most of these factors aren't new developments, with the exception of the Treasury report and the textile curbs. As such, we at MMS International view the dollar's decline as a managed correction of past strength, rather than as a sudden and shocking deterioration in the greenback's fundamentals. But amid a sea of troubles, a continued fall in the world's benchmark currency could pose risks for U.S. financial markets - and the Federal Reserve's desire to remain accommodative on monetary policy "for a considerable period."
Since President Richard Nixon jettisoned the gold standard in the early 1970s, the mostly free-floating dollar has been subject to the forces of trade and capital flows, verbal and rhetorical intervention by central bankers, and political pressures. According to monthly records maintained by the Federal Reserve, the nominal "major currencies" dollar index, which measures the greenback vs. the currencies of other major nations, peaked at 140.35 in March, 1985. It hit its nadir of 77.68 in April, 1995, after a trade spat with Japan over exports.
PLAYING BOTH SIDES. Sound familiar? At its present level of around 85, the dollar index is still some distance from its lows of the last decade. And on an inflation-adjusted basis of around 92, recent scant inflation makes the index's decline in real terms much less alarming.
Still, it doesn't make sense to downplay the risk of further dollar declines. The Bush Administration hasn't been particularly patient about achieving its policy agendas, whether geopolitical or economic. The fast approach of next year's Presidential election makes the recent dose of trade politics even more urgent for the Bush camp. The White House is seeking to head off calls for protectionism in Congress, while at the same time appealing to voters in steel- and textile-manufacturing states, who blame job losses on foreign competition (see BW Online, 11/11/03, "Will Bush Bend on Steel?").
An escalation of the trade disputes could send a more ominous signal to the market. The Chinese made a token gesture by agreeing to procure U.S. autos and auto parts recently, but the textile curbs are aimed at achieving faster change, as well as compliance with World Trade Organization timetables for opening China's borders, already agreed to by Beijing.
RATIONAL REACTION? Following the levy of tariffs on steel imports, the textile quotas appear to continue a pattern of trade interventionism. Sure, it can be noted that the quotas merely limit textile import "growth" to 7.5%. Still, if such trade issues cannot be settled in bilateral negotiations, it's likely the WTO will have the final say, and level heads will prevail in the end.
Yet the market reaction to such events can be far from rational in the near term. The Administration's equivocation on the "strong dollar" -- and its tiffs with major trading partners Japan and China on currency policy -- prods the markets to correct the U.S. trade and capital imbalances in their own inexorable way: through a declining dollar.
While some electioneering and strong-arming of U.S. trading partners may be understandable, or even justified, the Bush Administration would be wise to carefully weigh the economic and monetary implications.
AWKWARD POSITION. Plenty of evidence indicates that the U.S. economy is already chugging along in the latter half of 2003. The risk of destabilizing U.S. financial markets and raising the specter of inflation is probably not worth the export rewards of dramatically devaluing the dollar from here. Moreover, the President's pursuit of marginal gains on trade to appeal to specific constituencies could abbreviate the Fed's commitment to low rates for a "considerable period."
Any additional pressure on prices - whether from a falling dollar or rapidly increasing output growth -- could cause Alan Greenspan & Co. to take steps to rein in inflation. This would place U.S. policymakers in the awkward position of raising rates sooner and faster than the economy can withstand -- particularly if foreign appetite for Treasury holdings continues to wane.
The dollar has been in a steep downward trajectory since early 2002, and the natural adjustment in the U.S. current account and trade gaps probably doesn't require much more prodding at this stage, given the market's propensity to clobber the greenback at the first hint of bad news. Wallace is a senior market strategist for MMS International