AMERICAS: Will Stronger US Economy Act as Parachute for Dollar?, THE

Global Finance, Dec 2003 by Platt, Gordon

The US dollar's headlong plunge has suddenly slowed dramatically in response to better-than-expected reports on the economy, including stabilization of the employment market and a 7.2% rise in third-quarter gross domestic product.

The surge in US economic activity, combined with hints from the Federal Reserve that interest rates will eventually rise, have handed the dollar a parachute in its lengthy skydive, says David Gilmore, partner and economist at Connecticut-based Foreign Exchange Analytics.

The gaping current account deficit and the weak-dollar policy in Washington provide the gravitational pull on the dollar, Gilmore says. However, the roaring economy and growing risk the Fed will renege on its promise to keep monetary policy accommodative for a considerable period of time have created an environment in which it is difficult to sell the dollar, he says.

"Hence, I think the dollar is at the very least due to move to a far more gradual descent, and I would not rule out a reasonable bounce," Gilmore says. "Markets tend to be myopic, and the focus may well move to the parachute and away from terra firma," he adds.

Not everyone is convinced, however, that growth differentials between the US and the rest of the world are going to help the dollar.

Michael Rosenberg, global head of foreign exchange research at Deutsche Bank in New York, says he questions the validity of "the growing chorus of comments suggesting that a pickup in US growth will be supportive of the dollar."

For one thing, the US economy is not the only economy showing signs of strength, he says.The global economy is recovering, and growth differentials won't be a significant factor for the dollar, he adds.

"The argument that the pickup in US growth will lead to higher interest rates and a stronger dollar also is not holding up," Rosen berg says. "There has not been a shift in favor of US versus foreign yield spreads. The 50 basis-point spread in favor of Europe in short-term rates has remained stable," he says.

The related argument that stronger US growth will spark a rally in the stock market and invite capital inflows is not playing out either, Rosenberg says. From March through mid-November of this year, the German DAX index has outperformed the Standard & Poor's 500 stock index, he notes. Meanwhile, there has been no change in capital flows into the US.

"The big negative for the dollar is that the faster growth of imports relative to exports as the US economy advances will worsen the trade deficit," Rosenberg says.

Although the US trade deficit has stabilized on a monthly basis in the $39 billion to $40 billion range, US inventories are quite lean and will need to be replenished, he says. This implies that the trade deficit should begin to deteriorate again.