Over the past month, the value of the US dollar has fallen significantly with the once mighty dollar falling to an all-time low against the euro and a 31-year low against the Canadian dollar. For forex traders, the weakness of the dollar has provided many opportunities, but for the average person living in the United States, what does a weak dollar really mean? Since there are two sides to every coin, a weak coin also has its advantages and disadvantages.
At a time when the US housing market is contracting, the job market is deteriorating and consumer spending is at risk, the US economy needs a weaker dollar. This is the main reason why we do not expect the US government and the Federal Reserve to stand in the way of further dollar weakness.
Benefits of a weaker dollar
1) Increase in Exports –
One of the main reasons a weaker dollar will help the US economy is that it increases the competitiveness of US products. It drives foreign demand while maintaining domestic demand from US consumers. In the medium term, this benefits corporate America’s sales, eventually translating into more jobs and consumer spending. It also helps reduce the trade deficit, one of the most criticized aspects of the US economy.
2) Foreign Investment –
There are three different ways that foreign investment can help the US economy and the US dollar. In recent years, foreigners have been big buyers of real estate in the United States. According to a study by the National Association of Realtors, about one in five US realtors sold a second home in the year ending April 2007 to a foreign buyer. A third of these buyers come from Europe, a quarter from Asia and 16 percent from Latin America. As the US dollar continues to fall in lockstep with house prices, foreign buyers could provide the support the US housing market needs to avoid a big drop.
The second support would be in the form of a search for value in the US stock markets. If the dollar continues to fall, foreign investors can start investing in companies with strong fundamentals that are also less vulnerable to a US economic slowdown. Both factors depend on the US dollar showing signs of stabilization. Foreign investors will only jump in with size when they think dollar weakness is coming to an end. The third factor is less dependent on the outlook for the US dollar. A weaker dollar also makes corporate America more attractive buying targets. Sovereign wealth funds from countries like China and Dubai are flush with cash and looking for good investment opportunities.
3) Increase in Tourism –
Tourism represents a large part of the US economy. It supports the employment of more than 5.4 million workers and generates more than $550 billion in annual revenue. Canadians represent the largest group of travelers to the United States. We expect their share to increase further now that the Canadian dollar is trading at par with the US dollar. Earlier this year, a $250 hotel room was CAD$295, now it’s just CAD$250, a savings of more than 15 percent. Although the savings for Europeans aren’t that great, they’ll also see 5 to 10 percent off travel costs. More tourism is always good for an economy.
Disadvantages of a weaker dollar
1) Higher Costs of Foreign Goods –
The most immediate downside of a weaker dollar is the increased cost of foreign goods. With a trade deficit of $59.2 billion, American consumers import far more than they export. The number one country the United States imports from is Canada, which is why the recent strength of the Canadian dollar is so important. Canadian drugs, for example, may not be as cheap as they used to be. The same goes for European handbags and other luxury items.
2) Tighter monetary policy –
Higher costs for inflation from imports of foreign goods, so a weaker currency is generally inflationary. With oil prices hovering around $80 a barrel and the dollar hitting rock bottom, inflation is sure to pick up in the coming months. Martin Wolf of the Financial Times makes a fantastic comment when he said that “the resolution of each crisis lays the seeds of the next.” To get out of a crisis, the Federal Reserve will generally lower interest rates aggressively. We saw this after the Asian and Russian crises of 1997 and 1998. This eventually led to financial market bubbles, forcing the Fed to raise interest rates. Although inflation is not a big issue right now, the threat of inflationary pressures could prevent the Fed from lowering rates as much as it wanted or needed to.
3) Travel abroad becomes more expensive –
From a consumer point of view, the weakness of the US dollar makes it more expensive to travel abroad, especially to countries such as Europe and Australia. Since the beginning of the year, the Australian dollar has appreciated more than 10 percent against the US dollar. Due to currency fluctuations alone, travel to Australia has become 10 percent more expensive. The same goes for trips to Europe, except for the fact that the movement is smaller in percentage.
Can the US dollar fall further?
The answer is yes. A trend in the forex market can last much longer than many people would expect. We have seen one-way directional movements that last for months and in some cases even years. Interest rate prospects play a big role in the future direction of currencies, so with the market priced at another 125bps of easing by the end of next year, the US dollar could easily drop to 1.50 vs. to the euro. This is especially true if the ECB remains indifferent to the movement of the euro. At some point, the benefits of a weaker dollar, such as increased exports and foreign investment, will help turn around the US economy, at which point the dollar will begin to rise again.
What does this mean for your investments?
Regardless of whether you actively participate in or monitor the forex market, the value of the US dollar or currencies does matter. Companies that make a lot of sales abroad will benefit more because their foreign currency earnings will be higher when they are repatriated, not because they have sold more goods, but because their currency conversion earnings will be higher. The industries with the greatest exposure to foreign sales are energy, technology and consumer staples. Companies that produce raw materials also tend to benefit from a weak dollar, while the companies that will be hurt the most are the large importers. If you have a view of where the US dollar is headed or want to hedge against some of your stock market exposure, the purest way to do this would be to trade or invest in US dollars directly on the forex market.