Is the US dollar about to turn around?

For the first time in several years, the US dollar managed to gain value against other major currencies in the world. In the first three months of 2005, the US dollar rose by approximately five percent against the yen and the euro. Profits on the dollar should be considered significant, given that the United States still faces a growing trade imbalance. So far this year, currency traders have shifted their focus from the large trade deficit and the US current account to the higher levels of returns offered on US debt. The recent strength shown in the dollar has somewhat changed the mood in the financial markets regarding the future direction of the currency. A Bloomberg survey published earlier this week shows that major currency traders expect to see a weakness in the dollar later in the year, but sentiment among dollar bears is much weaker than at the beginning of the year.

The strength shown in the US currency so far in 2005 must 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 in the next few months. Signs of slower economic growth are likely to lead to a shift in the mood among currency traders towards the more fundamental problems facing the US economy. The trade deficit and the US current account show no signs of retreat any time soon. In fact, we expect the forthcoming trade data to show a further deterioration in the trade balance over the next few months. Major industrialized countries outside the United States continue to have anemic economic growth. This continues to put additional pressure on the US dollar as the US consumer continues to buy goods made in Europe, Japan and China.

While we expect the dollar to resume its gradual decline against most major currencies, the main substitute in our forecast is, of course, China. Recent information from the best decision-makers in China shows that the Chinese are in no hurry to adjust the current value of the yuan-dollar relationship. If any revaluation talks emerge later this year, the pressure on the US dollar will accelerate as currency traders buy the Japanese yen and other freely traded Asian currencies, which are likely to benefit from the revaluation.