Dollar Will Stay Weak for a Long Time

10/08/2007 12:00 am EST

Focus: GLOBAL

Knight Kiplinger

Editor-in-Chief, The Kiplinger Letter, Kiplinger's Personal Finance, and Kiplinger.com

Knight Kiplinger, editor-in-chief of the Kiplinger Letter, says the greenback is suffering from long-term weakness, and that could eventually boost rates and drag down growth.

What's ahead for the drooping dollar?

More of the same, with periodic rallies providing breaks in a longer-term drift lower.

The sluggish economy will take a toll through at least the middle of 2008. With growth slowing here more dramatically than in most other countries, currency traders will place more bets on euros, pounds, etc.

Lower interest rates will also hurt. Other countries won't move to cut their rates just because the Federal Reserve is doing it. That means more short-term currency investors will seek higher yields outside the US

The dollar will firm up in late 2008, when the US economy shows a bit of bounce. But the currency won't be in the clear. Fundamental global changes are at work that are eroding the dollar's historical role as the standard-bearer for most of the world. Fewer reserves will be held in dollars. Foreign countries are forgoing the safe harbor of the dollar to tap opportunities elsewhere with more growth potential.

And the euro is emerging as a keen competitor to the dollar. Sellers of oil and other commodities may soon be ready to accept either.

Still, the greenback won't collapse. The economy's resilience and the depth of US financial markets will always attract investors. But there is little reason to expect long rallies for the dollar.

For the economy and some US firms, the soft buck has benefits:

More exports. The US trade deficit is finally narrowing, now that aircraft, farm goods, and other key exports are racking up gains.

Less import competition. For example, US chemical firms' sales at home have risen at the expense of European and Japanese companies.

Higher earnings from overseas units. Their profits are worth more when they're converted back to dollars. Affiliate income from Europe, which accounts for more than half the income that US firms earn abroad, was up 14% in the first six months of 2007 over the same period of 2006.

But pricier imports are a burden for others facing cost hikes.

High import bills will add fuel to inflation, already stoked by wage costs. Plus foreign investors will demand higher interest rates on the US Treasuries they hold to offset currency-related losses.

Expect the 10-year Treasury to yield about 5% by mid-2008, up from 4.6% now, as mounting concerns about inflation come to the fore.

Mortgage rates won't move as much, especially on fixed loans. The benchmark 30-year fixed is likely to reach 6.5% around year-end and remain at about that level next year amid slack mortgage demand.
       
The same goes for investment-grade corporate bonds. Their yields, currently averaging 6%, will rise to only about 6.25% by mid-2008.  But riskier high-yield corporates will stay out of favor. Expect the average yield to climb to 10%-11% from the current 9%.

Upward pressure on interest rates will dampen economic growth. Along with the housing slump, it'll be a big challenge to any expansion.

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