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The strong euro and weak dollar are at equally critical points – can they navigate to safety?

by Tom Sieber

US rapper Jay-Z said ‘Money ain’t a thang’ on his 1998 hit of the same name, and the sentiment seems appropriate a decade on given the state of his country’s currency, which hit a fresh record low against the euro last week.

As early as November the world’s most financially successful rapper was personally cocking a snook at the greenback by waving a wad of euros in his video for the song Blue Magic. Given what has happened to the dollar since it seems unlikely he will reverse his preference now.

The current exchange rate between the euro and the US dollar is around the 1.59 mark, and despite a recent mini-rally in the greenback, most see the rate creeping to 1.60, with some analysts even predicting a future exchange rate of 1.65.

Can Europe cut it?

The ECB has of course been pursuing a very different strategy to the Fed. The former has not imitated the latter in aggressively cutting rates – an action which has seen the dollar become the second lowest yielding currency in the developed world, and instead focused on direct injections of liquidity. The ECB’s stance has been supported by continuing strength in the eurozone economy, which now looks under threat, but this imbalance in the two responses, which is being keenly felt in the currency markets, looks unlikely to shift overnight.

And while we are not talking about a scenario where people will be building shelters out of the stuff or engaging wheelbarrows to ferry it around, the continuing depreciation of the dollar will have slightly less drastic consequences.

It is being blamed for a spike in the oil price, with some observers saying continued depreciation could lead the cost of a barrel of oil to increase to $125.

In fact, all the dollar-priced commodities have been boosted. Copper hit record highs last week and gold has hit a three-week peak. Goldman Sachs has raised its gold price forecast, saying that the fundamentals for the dollar have continued to weaken.

Interestingly the falling dollar also appears, rather against logic, not to have narrowed the US trade deficit. Greg Anderson, of ABN Amro, says: ‘The US trade deficit for February was surprising in a number of ways. First, it defied expectations by widening to $62.3 billion. Markets had expected a narrowing of the deficit to about $57 billion.

‘Classic economic theory says a weaker dollar and slow US growth should cause US imports to decline. But that was another big surprise. Imports exploded, at least in the seasonally adjusted numbers. Seasonally adjusted imports rose 3.1% month on month and 16.4% year-on -year to a new record of $213.7 billion. This import expansion did not come as a result of oil prices.’

Anderson explains this paradox by highlighting the fact that, given that imports are so much bigger than exports, ‘exports need to rise about twice as fast as imports for the trade deficit to improve. That is not happening despite the fact that the US economy is much weaker that its trading partner’s economies. I suspect the reason is the fact that the US imports primarily raw materials and consumer goods, while it exports primarily capital goods. This has caused terms of trade to turn against the US.

‘I don’t think the terms of this trade shock will last very long, but it is yet another factor that will put downward pressure on the dollar over the next six months. Further dollar depreciation against local markets currencies in particular seems inevitable.’

In the zone

Unlikely as it may seem, while a weak dollar has accompanied a widening trade deficit in the US, a strong euro has seen the opposite occur in the eurozone. Recently released figures showed a swing to a small trade surplus in February. According to the economic research team at Societie Generale, a combination of slowing global growth and the rise of the euro will catch up with the eurozone in the end. ‘US growth will be close to zero through to the middle of next year. The stimulus package will boost growth mid-2009 but it could then fall back as the labour market continues to weaken. In Europe, the combination of weaker export demand and the euro’s appreciation will add to the slowdown already being felt as higher inflation squeezes consumers’ purchasing power.’

Director of research Dr Brian Hilliard adds: ‘Increases in the value of the euro to date and the impact of the financial turmoil will bite in the second half of this year and the ECB should start cutting [rates] in September.’

It will be interesting to see how the two currencies stack up then. The Fed is due to meet next week to decide on interest rates – and the minutes of the previous meeting suggest the fear of inflation could be a factor. A move to a euro-dollar exchange rate significantly above 1.60 could prompt the ECB to ease monetary policy earlier than Hilliard believes it will.