A strong dollar and effects on the common man

Posted in economy by moneymanagement on August 11, 2008

The dollar surged higher this week, hitting a five-month high against the euro and a 20-month peak against sterling amid a growing conviction that the effects of the credit crisis were spreading across the globe.

Mounting optimism that the US economy would outperform the rest of the developed world pushed the dollar to multi-month highs against leading currencies this week as the oil price resumed its downward path, providing support for equity markets.

The trigger for the greenback’s rally – and a sharp rise in European government bonds – came from comments by Jean-Claude Trichet, the president of the European Central Bank, following Thursday’s decision to leave eurozone interest rates unchanged.

The yield on the two-year German bond hit its lowest since May 20 2008.

Mr Trichet acknowledged that economic growth in the region was weakening – in effect taking further ECB rate rises off the table and underscoring the bleak message provided by a series of weak data releases, most notably from Germany. His remarks compounded increasingly gloomy outlooks in the UK and Japan.

Is the Dollar Smile Working?

www.seekingalfa.com explains, according to Stephen Jen, Luca Bindelli and Charles St-Arnaud in the Global Economic Forum. Morgan Stanley believes that the Dollar Smile will eventually work, admittedly with a delay.

As opinions among investors change particularly those on the U.S.s slowdown being felt primarily in the U.S. and also the low yield premium on USD assets Morgan Stanley foresees the following effects on the dollar:

[a] rally this year against the EUR and the GBP. In turn, the JPY and CHF could rally against the strengthening dollar, for as long as the U.S. is in a recession, which we believe will likely persist through 1H08. One by one, various parts of the rest of the world will start to show signs of a slowdown/deceleration. Even though we are of the view that this ‘economic re-coupling’ will be tentative and partial, financial coupling will likely push investors back into ‘fear mode’ and bond rather than equity flows will, perversely, support the dollar – consistent with our ‘Dollar Smile’ framework.

On decoupling:

while in the past, when the U.S. caught a cold, the rest of the world got pneumonia, these days, if the U.S. economy catches pneumonia, the rest of the worlds economy will catch a cold. At the same time, however, financial coupling is likely to have remained quite high, we have warned, and an outright bear market in the U.S. would likely lead to a bear equity market elsewhere – which is precisely what our equity strategists believe will be the case in 2008, at least in 1H.

While we are of the view that the degree of economic coupling has declined substantially in recent years, financial coupling is likely to have remained high – high enough to preserve the left side of the ‘Dollar Smile’.

Effects of a strong dollar

A weaker dollar offers more benefits than a stronger one. The cheaper dollar offers a lift to American exporters by making their products competitive in many parts of the world. And while a weak dollar usually makes imports expensive, import prices have so far climbed less than other currencies’ values because foreign producers have kept prices low to preserve market share in the United States.

The dollars strength, for example, makes it more difficult for certain U.S. industries, such as textiles and steel, to compete with foreign goods. Many export-oriented industries similarly suffer On the other hand, those industries purchasing imported raw materials or capital goods do so at a bargain, thanks to the dollars strength. This can lower their production costs and sale price. Example: industries using steel as a primary component of their product (such as autos, major appliances, and farm machinery) benefit from purchasing less expensive steel.

Just as U.S. consumers benefit from the increased purchasing power of the dollar so too do many U.S. industriesthereby creating jobs and wealth All import-dependent industries benefit.

Recession and a strong dollar

For those of us who feel national pride in a strong dollar here is a climb down.

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The above chart shows how over the years at each point of strength has coincided with recession (reflected by the grey bars). You might notice that the recession coincided with the low point for the Yen (or conversely, the strongest point for the dollar during this time period). In other words, the very strong dollar and the recession went hand in hand because the Federal Reserve raised interest rates beginning in 1999 and that led to the recession. Higher rates cause the dollar to strengthen, but they also inevitably slow down the economy. On the other hand, lower interest rates are positive for the economy, but often not for the dollar.

Higher interest rates Lower oil and gold prices Recession Slow down in exports Increase in imports Trouble

I welcome your views on the topic