Economics: The U.S. Dollar - What Lies Ahead?
New York: September 22, 2003
By John R. Stephenson

Anyone who has followed the world’s currency markets for the last six months should realize one obvious and unmistakable trend - the U.S. dollar has slid relative to most other major currencies. The Canadian dollar, on the other hand, has gone in the opposite direction of late, buoyed by a positive short term interest rate differential (with the U.S.) and an economy that appears to be improving.

The principal reason for a lower U.S. dollar is an ever-worsening current account deficit (see figure 1). This means that American consumers are demanding more foreign-made goods than foreigners are demanding U.S.-made goods. This results in a net outflow of dollars in order to pay for the foreign goods being demanded. Currency markets, like all other markets, are subject to the laws of supply and demand.

Figure 1: U.S. Current Account Balance


With the U.S. economy showing signs of improvement and the other major world economies (Japan, Europe) still mired in recession, the likelihood that demand for U.S.-made goods (by foreigners) will outstrip the demand (by Americans) for foreign-made goods is small. As well, the stock market crash of 2000 has caused many foreigners to repatriate their dollars. Although the U.S. stock markets are improving, direct foreign investment in the U.S. may be unable to help reverse the dollar’s slide.

Oftentimes a currency’s slide can be abated or reversed by Central bank intervention (Central banks around the world buy dollars). Recently, the Japanese, as well as the other major Asian economies, have been heavy buyers of surplus U.S. dollars - a strategy that serves to support the level of the U.S. dollar while preventing the value of their own currencies from rising significantly against the dollar. As can be seen from the Foreign Official Assets chart (figure 2) there has been a considerable rise in foreign central bank holdings of U.S. dollars in recent quarters. All this intervention makes it unlikely that further interventions will be as pervasive in the future.

Figure 2: Foreign Official Assets


>With the U.S. economy strengthening, the current account deficit at record levels and foreign Central bank intervention, the likelihood of a stronger dollar over the next year is remote. It is our opinion that the U.S. dollar could fall quite dramatically against other major world currencies over the next year.

What does this mean for investors? Consider having a portion of your equity portfolio in non-U.S. denominated stocks. Canadian energy companies such as Encana (ECA) or Talisman Resources (TLM) are excellent choices, as the fundamentals (tight supply and strong demand) for North American energy look very attractive for the foreseeable future.