The dollar: an accident waiting to happen

As investors eagerly offload their dollars, the value of the greenback has fallen against both sterling, the euro and the yen. But things have the potential to get a lot worse.

"While Americans were busy digesting their Thanksgiving feast, the rest of the world was barfing up dollars," says Peter Shiff on Late last week, the greenback was "carved up like a turkey", sliding 3% against the Swiss franc and 2.2% against the euro; it also slid by around 2% against the yen and the pound.

The sudden fall extended into this week, with the euro hitting a

20-month high of $1.32 and sterling edging up to a near 15-year high of $1.95. The dollar has now dropped out of its trading range of the past few months, while the fundamental outlook is grim, so it's no wonder most analysts expect further falls. Tim Fox of Dresdner Kleinwort Wasserstein reckons that a "tipping point" has been reached, heralding a downtrend; he sees the pound reaching $2 by March, a level not seen since 1992. Capital Economics is pencilling in a $1.40 euro next year.

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When it comes to currencies, "image is everything", as Bill King points out in The King Report. Investors have been put off by the slowing economy and the Iraq imbroglio has reduced America's prestige on the world stage. A major factor, however, is that there is now a growing feeling that the next move in US interest rates will be downward. For the first time since the euro's inception in 1999, a tightening cycle is underway in all major currency zones except the US: "yield-hungry investors have ever less reason to hold dollars", says the FT. Unwound carry trades (borrowing in low interest-rate countries and investing in higher-yielding markets) have also played a part.

A popular trade lately has been borrowing in yen and buying dollar-denominated assets, so that the gains would shrink, or even turn into losses, if the yen rises and the dollar falls.

Then there's the perennial worry over America's huge current-account deficit, which is set to reach $869bn this year. The US deficit with the rest of the world has been plugged by inflows of dollars from overseas over the past few years, especially from Asian central banks buying US bonds to keep their currencies low. This has kept US long-term interest rates low and propped up the economy, helping to finance consumption. But last week, an official at the People's Bank of China warned that a weakening dollar was putting China's massive foreign-currency reserves 70% of the $1trn total is thought to be in dollars at risk of depreciation; comments that were interpreted as heralding dollar sales from China. All these factors, as Capital Economics points out, were hardly new last week: the ongoing problem of a huge current-account deficit has made a fall in the dollar "an accident waiting to happen".

The US current-account deficit has reached a whopping 6.6% of GDP and economists reckon the dollar would need to fall by 20% to 30% to reduce it to a sustainable level. Inflows to plug the deficit can no longer be taken for granted. There has been increasing talk of central banks diversifying their reserves, thus removing a key source of financing; Russia, Italy and the

United Arab Emirates plan to lower their dollar holdings, for instance. China will soon reach the stage when internal demand is strong enough for the economy not to depend on exports, says Clive Maund on, and there will be no further incentive to accumulate US bonds. An ongoing worry is that a dollar slide turns into a rout as foreigners tire of holding falling greenbacks and propping up the US economy.

But the main danger stems not from Asian central banks, says Martin Hutchinson on it's hardly in their interest to undermine confidence in their dollar by announcing sales, and their inflows comprised just a sixth of the total this year. Private investments, most of which went into US corporate debt this year notably overvalued junk bonds are the problem. Losses on both the bonds and dollars could prompt a stampede out of the relatively illiquid junk bond market and a sharp drop in the greenback, damaging the dollar's "safe haven status" among more conservative investors. "The resulting debacle would not be pretty."