Why a Weak Dollar Isn’t Always Good for Trade

02/10/2010 12:01 am EST

Focus: FOREX

Kathy Lien

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

Although the global economic calendar is relatively light this week, trade is one of the primary focuses. Yesterday morning, Germany and the UK released their trade numbers and we learned that while the trade surplus in Germany increased, the trade deficit in the UK rose.  

Today, the US and Canada will release a report on their latest trade conditions, and based upon the market’s forecasts, economists are looking for the trade deficits of both countries to shrink.

With so many countries releasing trade numbers this week, we thought it would be interesting to look at how trade balances of various countries compare. On the most fundamental level, currencies move on supply and demand, and there is no greater demand for currencies than for import and export transactions.

If we lived in a world where there was no speculation and currencies only moved based upon import and export transactions, then the countries with the largest surpluses would see a natural demand by importers to buy their currencies. The currencies of countries running large trade deficits, on the other hand, would normally face selling pressure.

Yet in reality, trade volumes are not the only factors driving currencies. Of the eight major economies that we follow, the US has the largest deficit, while the euro zone and Japan have the largest trade surpluses.


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Is a weak dollar good or bad for trade?

One of the biggest misnomers in the forex markets is that a weak dollar tends to narrow the trade deficit because it encourages exports. As you can see from the chart below, over the past few years, the US trade deficit has increased even though the dollar has fallen.

Although this could be partially attributed to the global recession sapping demand, our chart goes back to 2000 and it is quite clear that the dollar index and the US trade balance actually had a positive and not a negative correlation during this span of time. In other words, the trade deficit increased as the dollar weakened.

This relationship still holds with the rise in the dollar in 2008 coinciding with a sharp improvement in trade. Based upon this correlation, the recent strength in the dollar actually points to a narrow trade balance report.


Click to Enlarge

By Kathy Lien of GFTForex.com

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