The Pros and Cons of a Weak Dollar

05/27/2009 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

With traders in the US and UK coming off their holiday weekends, most people would expect a quiet day in the foreign exchange market. Unfortunately, that has not been the case with the EUR/USD and GBP/USD enjoying a 100-pip trading range. On Friday, we talked about how the trading range in the EUR/USD between 2006 and 2008 averaged 50 pips on Memorial Day Monday, but the possibility of unusually active trading should not be overlooked because the EUR/USD saw larger moves in 2005 and 2004. The daily price action of the major currency pairs masked intraday rollercoaster-like moves, which were partially triggered by reports that North Korea has conducted another missile test. Views on the dollar continue to dominate the price action in the currency markets, and so far, traders remain bearish US dollars. With the greenback depreciating significantly since the beginning of the month, it is interesting to consider the pros and cons of a weaker dollar.

Benefits of a Weaker Dollar

At a time when a recovery in the US economy is all but certain, a weaker dollar solidifies the foundation for stabilization. One of the primary reasons why a weaker dollar will help the US economy is because it boosts foreign demand while keeping US consumer demand domestic. A weaker dollar increases the competitiveness of US goods, benefitting the sales of US corporations and manufacturing activity. Hopefully, this will reduce the trade deficit and translate into more jobs and stronger consumer spending. A weaker dollar also helps the US tourism industry and mergers and acquisitions. The recent decline in the dollar is concerning for foreign investors who already hold dollar-denominated assets, but for investors who are looking to gain exposure to US investments, a cheaper currency makes US corporations more attractive acquisition targets. Therefore, in this current environment, we do not expect the US government and the Federal Reserve to stand in the way of further dollar weakness because it helps more than hurts the US economy.

Disadvantages of a Weaker Dollar

The primary disadvantage of a weaker dollar is inflation. We have already seen oil prices tick higher as a direct result of the dollar’s weakness, and other commodities have followed suit. Inflation is always a problem, but if it comes at a time when the consumers cannot handle higher prices and when the central bank’s policies could drive runaway inflation, it is even more concerning. Oil prices have a very strong correlation with consumer prices, so if the dollar continues to fall, we could see inflation continue to rise. The risk is that if inflation gets out of hand, the central bank may need to respond with tighter monetary policy. Martin Wolf of the Financial Times once said, “The resolution of each crisis lays the seeds of the next.” In order to get out of a crisis, the Federal Reserve will usually lower interest rates aggressively. We saw this after the Asian and Russian crises of 1997 and 1998, which eventually led to bubbles in the financial market, forcing the Fed to hike interest rates. Dollar weakness also raises the cost of foreign goods and international travel.

Consumer Confidence: Weak but Improving

The Conference Board’s consumer confidence report will be the most market-moving piece of economic data for the US dollar this week. Although confidence will remain weak, we expect it to improve. The recent strength in the equity market and the prior increase in the University of Michigan consumer sentiment report suggest that we will see a dollar-positive outcome. In addition to confidence, the S&P/Case-Shiller housing price index, and the Richmond and Dallas Fed manufacturing surveys are due for release. Housing prices are still expected to fall on an annualized basis, albeit at a slower pace, while manufacturing sector activity should improve.

By Kathy Lien, Director of Currency Research at GFTForex.com

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