[DanRath]

The view is that the USD is in a multi-year downtrend and that it will see a succession of lower highs and lows over the next few years, as it did in the 1990s. There are many similarities between the USD’s trend in the last few years and that of the late 1980s and early 1990s. The choppy USD downtrend of the past couple of years bears a strong resemblance to the pattern of the late 1980s and early 1990s. If this pattern holds, the USD will continue to trend lower over the next few years, with lower highs and lows. A key factor to be aware of is that the current USD downtrend is choppier than was the case from 2002-04. The key factor weighing on the USD now is expected to be the fiscal deficit rather than current account deficit.

In the 1980s, the USD fell sharply starting in 1985, after the Plaza Accord, before stabilising in 1988-89. It then gradually trended lower from 1989-94, despite periodic bouts of upside correction. This is a very similar pattern to what we have seen in the last few years. From 2002-04, the USD fell sharply, only to stabilise in 2005-06 before going into a choppy downtrend. If history is any guide, the USD should keep trending lower from 2009 through 2012, albeit in a choppy and erratic fashion. During the 1989-1992 periods, the USD (as reflected by the DXY index) fell some 24.5% from June 1989 to September 1992. Once US policy interest rates bottomed, so did the USD. More recently, after the Fed funds rate peaked at the end of January 1995, the USD fell 9.8% in anticipation of rate cuts between January-June 1995, but then rallied by around 9.0% in the following 11 months (June 1995 to May 1996). In 1999-2000, the USD rallied during the hiking cycle, by around 14% from June 1999 to May 2000. It then fell by 8.5% in anticipation of rate cuts, but started to rally again once the rate-cutting cycle got underway. In H2-2008 and Q1-2009, the USD strengthened as a result of global deleveraging, investor repatriation, and safe-haven flows into US Treasury markets.

As global economic expectations stabilise and risk appetite improves, the USD should fall as it did in 2002-04, after the brief US recession in 2001. The same thing is playing out now, as US investors boost foreign asset allocations and capital inflows into the US slow. Some do not buy the argument that the USD may strengthen near-term as the US emerges from recession before regions such as the Eurozone, supported by extraordinary fiscal and monetary policy measures. First, the trade and financial linkages between the US and Eurozone are so strong that if the US recovers, the Eurozone should also recover with a relatively short time lag. Second, the extraordinary US policy measures have consequences. In particular, the US fiscal deficit is set to rise to alarming levels in coming years, with a conservative estimate putting the 2009 deficit at USD 1.9trn, or 13.6% of GDP. In addition, the Fed is expected to set to keep interest rates at ultra-low levels for an extended period, and additional quantitative easing measures are still possible. As such, there is expectation that any other central bank to reach the Fed’s level of aggressiveness in terms of QE.

Hence, whereas the USD’s fall in 2002-04 was driven by concerns about the rising US current account deficit, the dominant factors now are the widening fiscal deficit and expansive monetary policy. As such, the USD is expected to be used increasingly as a funding currency to invest in higher-beta assets. One common trigger behind the USD fall in 2002-04 and the one expected in the coming years is likely to be a broad increase in global money supply. At the beginning of the financial crisis, US bank debt to GDP was at its highest level on record, as was US consumer debt. It will take years rather than months to repair shattered balance sheets. However, global money supply growth is already showing signs of picking up again, and this means we are likely to see the USD give ground once more. Such increases in money supply are multi-year events, and so will the USD decline be. A USD recovery will not happen until Fed policy is normalised starting in 2011.