US dollar is down, but not yet out

With interest rates near zero and the Federal Reserve printing money to prop up the economy, the dollar index has hit a 14-month low. But it's too early to write the greenback off yet.

Last week Tim Geithner became the latest US Treasury Secretary to say he believes in a strong dollar. The dollar index, which tracks the greenback's performance against a basket of major trading partners' currencies, promptly hit a 14-month low of under 76, not far off its record low of March 2008.

Why the dollar is sliding

And it's no wonder. Interest rates are near zero and the Federal Reserve has been printing money to prop up the economy. Fiscal policy has been expansionary too. The "worst budget conditions for 75 years", due to the brutal recession, will result in a deficit of around 10% this year. This isn't a short-term problem. The deficit will still be around 6.5% in 2019, says Roger Altman in the Financial Times, after which healthcare liabilities will rocket. The "lack of any clear path" to shrink the deficit fuels fears that the US will inflate its way out of its huge debt load by debasing the dollar, says Edward Hadas on Breakingviews.

Then there's the carry trade. Thanks to rock-bottom interest rates, the dollar has become a popular currency to borrow and then sell, in order to park the cash in higher-yielding currencies and assets. This trend will strengthen as global risk appetite remains high: expect further dollar weakness against the high-yielding commodity currencies, says Callum Henderson of Standard Chartered.

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And all the recent "hubbub" about its demise as the dominant reserve currency is also denting the dollar, says Stephen Foley in The Independent. "You would think we have passed into a new world economic order." Earlier this year, China suggested that the International Monetary Fund's (IMF) special drawing rights could be a new reserve currency, while last week Middle Eastern states and China were rumoured to have discussed trading oil in a basket of currencies rather than the dollar.

It's too early to write it off

But all this is wildly premature. For starters, the practical difficulties are immense, says Foley. The IMF seems incapable of "having a civilised debate" on how many seats each country gets, let alone what currency weightings might be.

IMF estimates suggest that the dollar's share of global foreign-exchange reserves is falling as central banks diversify their cash piles. Dollars now comprise 63% of global reserves, from more than 70% a decade ago. But China, the main buyer of US debt, increased its holding of Treasuries to $800bn in July, from $780bn at the end of June, says Capital Economics. "The dollar is still entrenched as the world's dominant reserve currency." A Chinese official told the FT in June that "in the short term, I don't think we can find another currency" to replace the dollar.

If China, the world's largest holder of reserves and America's key creditor, ditches dollars, it would prompt a sharp slide in the value of its huge pile of dollar-based assets and cause a recession in the US by driving up long-term interest rates. Even a weakening dollar causes difficulty, since China and the rest of Asia relies on exports to the US, a growth model that is likely to take years to change. Last year China repegged the yuan to the dollar and last week Asian central banks intervened in the foreign-exchange market to slow the dollar's fall. As Jeremy Warner puts it on, for all the talk about the demise of the dollar, "the fact of the matter is that Asia isn't yet quite ready for it".

What next?

And while the dollar remains the world's reserve currency, it should benefit from demand for a safe haven when investors are rattled, as we saw early this year. Given that the global recovery is likely to disappoint, which will reduce risk appetite, the dollar may well bounce back in the next few months, as Capital Economics points out. The greenback is down, but not yet out.