U.S. Dollar Weakness is in the Eye of the Beholder - May 17, 2006
By Stephen S. Poloz, Senior Vice-President, Financing Products Group, Export Development CanadaThe U.S. dollar has been dropping in the past few months, prompting many to forecast its ultimate demise, yet again. Canadian observers are particularly sensitive to this issue, as many perceive that a key reason for Canadian dollar strength is weakness in the U.S. dollar.
As is almost always the case, a little historical perspective can be very helpful. It is important to define the U.S. dollar carefully, because there are many other currencies typically quoted in U.S. terms. Rather than focusing on one exchange rate, such as that for the euro, pound, yen or Swiss franc, economists prefer to analyze a U.S. dollar index measured against a basket of currencies, with each currency weighted according to its importance to U.S. trade. The most widely used of such indexes is that produced continuously by J.P Morgan, the U.S. investment bank.
Examining the U.S. trade-weighted exchange rate during the past year certainly conveys the impression that the dollar has fallen off a cliff since early April. But the drop has actually only been about 4%, and if we go back to the high point in the past year, which was last November, the total drop has only been a bit more than 5%. Hardly a crash, but of course it is always possible that it represents the beginning of something bigger.
But let’s go back a little further, to the beginning of the present global business cycle in 1994-95. The world economy was in great shape at that time, perhaps a little too good, and tighter monetary conditions produced a slowdown that began in the U.S., spread to other countries, and eventually led to the Asian crisis, the Russian crisis, the Brazilian crisis and a deep global slowdown, especially in the developing world. The global economy recovered during 2002-03, reached full speed in 2004, and has been easing back to normal speed during 2005-06.
That’s one complete cycle for the world. During the first half of this cycle (1995-2001) the U.S. dollar rose by about 30%, as the world economy slowed and staggered from one crisis to another. Since then, the dollar has retreated by about two-thirds of that amount as the world economy recovered. By that analysis, the dollar could have some further downside risk, but the conditions emerging now are virtually identical to those of 1995 – central banks are tightening, a slowdown is emerging in the U.S., and it will spread around the world during the rest of 2006-07. The world is in better shape today than it was in 1997, so no crises seem likely, but the dollar nevertheless should firm during the next 12-18 months as the world economy moderates.
And then there is the long history of the dollar. During the past 30 years, the dollar’s fluctuations span a range of plus or minus 25-30%. The lows were in 1978-80 and 1990-95, and the highs were in 1984-85 and 2001-2002. On this analysis, the dollar is near the middle of its long-term fluctuation range – a reasonable value given the current stage of the global business cycle.
The bottom line? The U.S. dollar is not weak. It is well within its normal historical range given the condition of the world economy. Furthermore, emerging global conditions point to a stronger U.S. dollar, not a weaker one – not to mention a softer Canadian dollar, too.
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