A Comeback for the Dollar?

Dollar comeback: Strength to follow - at Moneyweek.co.uk - the best of the week's international financial media.

The US dollar is set to rebound against other major currencies ending its recent three-year slide, according to Fisher Investments, a discretionary investment manager. Loose monetary policy at the US Federal Reserve has hurt the dollar, but this is expected to change, heralding an increase in short-term interest rates and a reduction in excess liquidity.

Andrew Teufel, Director of Research at Fisher Investments supports this upbeat forecast for the US dollar, debunking five currency myths cited as cause for the greenback's continued decline:

1) The US dollar has just begun to fall

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The US dollar has been falling for three consecutive years: history if nothing else suggests the greenback should recover in 2005. Major currencies tend not to experience longer than three-year cycles, strengthening or weakening against each other. Relative monetary policy determines exchange rates, and while the Fed is tightening, others - the Bank of England, ECB, and Bank of Japan are holding steady. Real interest rate differentials can serve as a proxy for relative monetary policy, and within the last several months this has swung in favour of the US dollar.

2) Trade balances, foreign policy and international popularity drive currencies

This is a common misconception: it is supply and demand that give currencies their relative value with other considerations being little more than background noise. Supply is determined by the issuing central bank; demand is principally determined by the amount of economic activity conducted in that currency. Exchange rates, on the other hand, reflect the value of one currency, quoted in another's terms. It is an entirely relative measure and has no absolute meaning. Increases in demand or decreases in supply drive one currency's exchange rate up versus another.

3) The US dollar must fall because it has been falling a crisis is on the way

Crises are rarely predicted accurately and when sentiment reaches an extreme a turning point is often near. Relative to sterling and the euro, the US dollar has already fallen more than 30% from highs in 2001. Fisher Investments believe that the US dollar crisis' is now past and emphasises, as with any financial asset, that past performance is not indicative of future returns.

4) The huge US budget deficit will cause the US dollar to fall further

Exchange rates are not dictated by budget deficits. They are monetary phenomena, while budget deficits are fiscal. Linking budget deficit to weak currency proves unfounded historically. For instance, the US dollar rose in the 1990s when the US ran similarly large budget deficits as a percentage of GDP.

5) The US current account deficit will cause the US dollar to fall further

Current accounts have no significant predictive power when it comes to exchange rates. Over the last 25 years the US dollar has experienced periods of strength and weakness despite ever increasing current account deficits. Similarly, in the last few years, the currencies of the UK, Australia and New Zealand have appreciated despite significant current account deficits.

Fisher Investments Director of Research, Andrew Teufel said, "Speculation over the direction of the US dollar has been rife, with many respected market commentators teetering on the edge of hysterical. Investors need to be more circumspect before making rash hedges against the US dollar and put the current situation into its historical context. Looking at hard facts rather than popular myths, we are confident that 2005 will see a significant reversal of the greenback's recent performance.

Fisher Investments