Is the U.S. dollar about to plunge?

By Money Matters Editors

Where’s the U.S. dollar headed from here? Well, if you’re in the camp that argues that both monetary and fiscal stimulus guarantee rising U.S. inflation, the dollar will likely weaken in the immediate quarters ahead, and probably for longer.

But if you’re in the camp that argues that given asset destruction, massive job lay-offs, and price power that is non-existent, the dollar will hold its own against the world’s other major currencies.

The dollar weakened about one-half cent Wednesday to $1.4811 and $1.6436 versus the euro and British pound, respectively. The dollar was virtually unchanged versus Japan’s yen at 91.13 yen. The dollar has weakened about 7 percent versus the euro and about 8.5 percent versus the pound so far in 2009. The buck is virtually unchanged versus the yen this year.


Autumn: season of decision for dollar?

Further, the autumn could prove to be ‘the season of decision’ for the dollar. The U.S.’s structural budget deficit – that’s the deficit that will likely exist whether the economy is in expansion or recession – is in the $300-350 billion range (including an expiration of the 2001 Bush tax cut), and that fact, combined with institutional investors re-evaluating portfolios as they return from summer vacations (when trading volumes are light) could result in institutions rotating out of dollar-based investments, weakening the dollar. That all-the-more underscores the need for the U.S. Congress to cut the budget deficit, and health care reform is a major factor in that effort, due to the projected increases in federal health care spending without health care reform.

Also, if serious deficit reduction doesn’t occur, and institutions start decreasing their dollar-denominated assets and dollar positions, emerging market giants China, India and Russia might combine with other large U.S. public debt holders Japan and Saudi Arabia and renew their effort to create an alternate global reserve currency – further weakening the dollar. Just as bad, any mass sale of U.S. government debt would increase interest rates in the U.S.- commercial and personal - presenting another hurdle to economic recover

One factor that could work in favor of the dollar? U.S. GDP growth. You read correctly: U.S. GDP growth. The currency market is starting to price-in capital flight from the U.S. to healthier emerging markets economies, particularly those in Asia, which are likely to register impressive growth rates as the global economic recovery takes hold. All other factors being equal, capital chases return, and most economic models show stronger GDP growth in Asia, not the U.S., in the recovery’s initial stage.

However, U.S. GDP growth could surprise. To be sure, no one expects the United States to return to Clinton administration-era, 300,000-job-gain months, but the recovery could be stronger than expected in Q3/Q4 2009 and Q1/Q2 2010, particularly if the housing sector snaps back quicker. And the latter scenario would be bullish for the dollar, leaving the dollar bears on the short end of a dollar-short stick.

What should investors monitor? Again, keep your eye on the U.S. budget deficit: any sign that Congress will not take the difficult but necessary steps to  reduce it will likely weaken the dollar further. Also monitor the condition of major U.S. banks: any sign that some may need more public assistance (translation: taxpayer funds) to re-capitalize implies more government borrowing, which would also weigh on the buck.