The Upshot of the Dollar's Fall

The dollar's descent to record lows has many market players fretting, but there are positives, too. Here's what you need to know

The U.S. dollar fell to an all-time low Nov. 7, pushed over the edge by some off-the-cuff comments from Chinese officials.

But in the complex world of currency markets, things are not always as they appear. While a dollar in the dumps might look like a stain on U.S. pride and prestige, it might also be good news for American consumers, workers, and companies.

Here are several key lessons to learn from the dollar's slide:

1. The U.S. dollar really did hit a historic milestone on Nov. 7.

The dollar has been hitting record lows against the euro for years, but those records aren't very surprising because the euro is a new kid on the block, only created in 1999. On Nov. 7, the dollar hit a true milestone when it surpassed the spring of 1995 low against the Deutsche Mark, the equivalent of about $1.455 to $1.457, according to Marc Chandler, chief foreign exchange strategist at Brown Brothers Harriman.

On Nov. 7 the euro hit a high of $1.473 before pulling back a bit by the end of the day. At the end of the day, the euro was up 0.57%, to $1.4641.

2. Ignore the loose talk.

The dollar's plunge started when some Chinese central bank officials were quoted suggesting China would be diversifying its $1.4 trillion in foreign currency reserves, moving away from dollar holdings. But Chandler says those officials shouldn't have been taken seriously because they have little power: It would be like the mayor of Milwaukee making comments on the war in Iraq, he says.

Many already assumed China and other Asian central banks were diversifying their holdings, but they're not necessarily selling dollars, just buying extra euros. "This is a question of psychology," Chandler says. The Chinese comments "gave market participants an excuse to do what they wanted to do." Also, says Standard & Poor's European economist Jean-Michel Six, "There is a bit of political posturing here." China is pushing back on U.S. demands that it revalue its currency. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

One Chinese official was quoted saying the dollar is "losing its status as the world currency." There's not a lot of evidence for this contention, Chandler says. Despite the drop in the dollar's value, commodities such as oil and wheat are still traded all around the world in U.S. currency. U.S. Treasury bills are still a popular safe haven for investors all over the world. Treasury prices actually rose on Nov. 7.

3. So why did the dollar fall?

Look at economic fundamentals. Money moves across borders, chasing extra returns. So currencies tend to rise when the markets expect strong economic growth and to fall when a slowdown may be coming.

This economic strength or weakness is reflected in yields on bonds and interest rates. Right now, Keith Hembre, chief economist at First American Funds, says the bond markets seem to expect many more interest rate cuts from the Federal Reserve in the next several months. That means the markets also are expecting a deep slowdown in the U.S. So it's no surprise that investors are moving money out of dollars and into other currencies that will give them better returns.

4. Will the dollar keep falling?

It's hard to say, but "there is a lot of bad news that's already priced into the market," Hembre says. In other words, expectations in the bond market are already so low for the U.S. economy that they're unlikely to fall all that much further.

Chandler expects the dollar to keep falling until the end of the year but then rebound next year.

Andrew Bernard, professor of international economics at Dartmouth College's Tuck School of Business, warns it's very hard to predict currency movements in the near term. But don't expect the dollar to revive "until the U.S. economy starts picking up again," he says.

5. A weak dollar is bad for some, but might actually help the U.S. economy.

U.S. tourists abroad don't appreciate a cheap dollar, and neither do foreign companies selling into the U.S.

But otherwise, Hembre says, a weak dollar can actually stimulate economic growth in the U.S. A weak dollar makes U.S. exporter's products more competitive in the rest of the world, for example. The U.S.'s trade deficit with the rest of the world has narrowed as exports boom, eliminating the deficit's drag on U.S. growth, writes Deutsche Bank (DB) economist Carl Riccadonna. A weaker dollar also can help employment, as multinational companies choose to hire relatively cheaper workers in the U.S. Investors are also more likely to look for bargains in the relatively cheap U.S.

6. The big dangers: inflation and energy costs.

When the dollar falls, imported goods are naturally more expensive, pushing up prices. However, many experts don't see signs that a weak dollar is causing inflation yet. "It does add a little inflationary pressure," Bernard says, but he adds that the U.S. economy is so large and competitive that most companies don't really get an opportunity to raise their prices.

The one area where a weak dollar hurts, however, is in commodity prices. Oil prices are pushing up close to $100 per barrel. That could hurt growth in the U.S., but Europe wasn't hit as hard because it's paying for fuel in more valuable euros.

Rising inflation can pose a special challenge to the Federal Reserve. The threat of inflation can stop policymakers from cutting interest rates to stimulate economic growth.

7. Governments won't intervene unless things get really bad.

The world's central bankers seem surprisingly relaxed about the slide of the dollar. Few observers expect finance officials from the U.S., Europe, or Asia to intervene in currency markets unless the dollar crashes in a big way. A disorderly fall for the dollar might prompt action, but otherwise bankers are expected to sit on their hands.

8. Eventually the cycle will turn.

Right now, the Federal Reserve is cutting interest rates and the U.S. economy seems to be slowing. Next year, many expect those rate cuts to pay off, as the U.S. economy perks up again. At the same time, however, European and other bankers may begin cutting rates to stimulate their economies.

In that scenario, the dollar probably would start to rise and the euro start to fall. S&P economist Six predicts the dollar will hit bottom sometime in the middle of 2008, landing at $1.52 or $1.53 per euro. But then he expects the dollar to be back to $1.45 or $1.40 by the beginning of 2009.

Under any set of circumstances, a big rebound for the dollar isn't expected for quite a while. Americans will have to get over the embarrassment of a weak currency, perhaps by remembering that a lower buck could help keep the U.S. export machine humming along.

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