Why the Dollar May Be Ready for a Rebound

As outlooks for the euro zone and Britain dim, central bankers will likely be forced to lower interest rates, creating conditions that could restore some of the U.S. currency's value

It's not easy to be bullish on the dollar these days, especially amid the latest round of financial market turmoil and dim prospects for U.S. growth. However, the depressing effects of tight credit and record-high oil prices are now spreading overseas, putting other major economies and their currencies in a less favorable light. Clearly, the greenback still faces a rough road in coming months, but several important pieces necessary for a bottoming out in the dollar are starting to fall into place.

After two years of stability in 2005 and 2006, the dollar has swooned 13% against a basket of major currencies since early 2007. The reasons: Prospects for U.S. growth relative to those overseas began to fade, and the Federal Reserve started a series of sharp cuts in interest rates, while other central banks were either holding rates steady or raising them, as in the case of the European Central Bank (ECB). As a result, dollar-based assets lost some of their attractiveness compared with those valued in other currencies.

Now the tables are starting to turn, especially for Europe. German industrial production plunged in May, with similar sharp declines in France, Italy, and Sweden. Economists now expect the economy of the 15-nation euro zone to contract in the second quarter and remain weak in the second half. They are also downgrading their forecasts for Britain, which faces a rising risk of recession. And the Bank of Japan recently cut Japan's growth forecast. Despite dim prospects for U.S. growth in the second half, many economists now think Europe and Japan will perform even worse.

This means the interest-rate outlook is also changing. Unless the U.S. falls into a severe recession, the Federal Reserve appears to be finished cutting rates, and some policymakers are already calling for hikes. At some point, other central banks will likely be forced to reduce rates. Lower oil prices would facilitate that decision, especially at the ECB, where worries about the broader inflation consequences of costlier energy are holding rates up. Even the recent 10% drop in oil prices, if sustained, would significantly reduce global inflation next year.

In addition to these shifting trends, the euro and the British pound are already overvalued relative to the dollar. Theoretically, a dollar should have the same purchasing power in all countries, meaning that an identical product, such as McDonald's Big Mac, should cost the same. In fact, based on 2007 data, the burger costs 22% more in Europe than in the U.S., according to the latest reading on The Economist's popular Big Mac Index. Employing similar but more complicated analytics, most currency analysts believe the euro is now 20% to 30% overvalued relative to the dollar.

Of course, U.S. imbalances, especially in foreign trade, will limit any rebound in the greenback. However, before its latest slide began in 2007, the dollar had fallen 26% from its overvalued level in 2002, more than enough to boost U.S. competitiveness. As a result, booming exports are shrinking the U.S. current-account deficit, a measure that reflects the U.S. need for foreign investment and is driven mainly by the trade gap. This deficit is set to fall to about 4.5% of gross domestic product this year, from a peak of 6.6% 2 1/2 years ago. That means the U.S., while still hugely dependent on foreign money, is becoming less needy.

Even during the recent financial turmoil, the U.S. has not struggled to attract foreign funds. Over the past year, net foreign purchases of U.S. long-term securities have averaged $60 billion per month, enough to cover the current-account deficit. Now many dollar-based assets are looking even cheaper relative to those of other key currencies, a factor that will continue to draw foreign funds, including those from other central banks looking for places to park their reserve holdings.

Clearly, the dollar's outlook will depend greatly on the course of the U.S. economy in the second half. But barring a severe recession, chances are rising that the greenback will regain some of its luster by next year.

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