[cppene]

Dollar strength last year and weakness thus far in 2009 largely reflect the ebb and flow of investor risk appetite. However, that relationship is not sustainable. Over time, the dollar’s external value ought to reflect valuations, relative growth rates (and expected returns), as well as the evolution of external imbalances.

In the coming six months the dollar ought to be supported against European currencies and the yen on the basis that significant US fiscal and monetary policy stimulus ought to promote somewhat stronger—though not strong— growth in the US relative to other advanced economies. The dollar’s gains are likely to be modest.

Over time, however, the dollar remains a fundamentally weak currency. Large structural US fiscal and current account deficits are likely to erode investor willingness to hold US assets, producing a weaker dollar. Correcting the US fiscal imbalance will probably require a rising share of taxation in GDP, which is likely to reduce trend growth and returns in the US economy, a negative for the dollar. Commodity currencies are likely to fare best, supported by improving terms of trade.

Asian exchange rate appreciation, long anticipated, is likely to evolve more slowly than many expect. In a more uncertain global economic environment, China is likely to permit only a gradual renminbi appreciation, while the yen has limited fundamental upside.