Is the US dollar about to reverse course?

For the first time in several years, the US dollar has managed to gain value against other major currencies in the world. During the first three months of 2005, the US dollar rose by about five percent against both the yen and the euro. The gains in the dollar should be considered significant if we consider that the United States is still facing a growing trade imbalance. So far this year, foreign exchange traders have shifted their focus from large U.S. trade and current account deficits to the higher rates of return offered on U.S. debt. The recent strength shown in the dollar has slightly changed the sentiment of financial markets on the future direction of the currency. A Bloomberg poll released earlier this week shows that major currency traders expect the dollar’s weakness to pick up later this year, but sentiment among dollar bearers is much weaker than earlier this year. .

The strength shown in the US currency so far in 2005 should be short-lived. The strong growth of Gross Domestic Product (GDP) over the last eighteen months will begin to show signs of approaching more normal levels over the next two months. Signs of slower economic growth are likely to provoke a shift in sentiment among foreign exchange traders towards the more fundamental problems facing the US economy. The U.S. trade and current account deficits show no signs of receding soon. In fact, we expect the next trade figures to show a further deterioration in the trade balance over the coming months. Major industrialized nations outside the United States continue to experience anemic economic growth. This continues to put even more pressure on the US dollar, as the US consumer continues to buy goods produced in Europe, Japan and China.

While we expect the dollar to resume its gradual fall against most major currencies, the main wildcard of our forecast is, of course, China. Recent information from China’s top decision makers indicates that the Chinese are in no hurry to adjust the current value of the yuan-dollar ratio. If at the end of the year there were any talks about a possible revaluation, downward pressure on the US dollar would accelerate, as foreign exchange traders would buy the Japanese yen and other free-trade Asian currencies, which are likely to they will benefit from a revaluation.