Why the USD will continue
to weaken
Sani Hamid
February 4, 2004
 For
those who have had doubts creep in after the sharp fall in the
price of gold recently, here's a chart help clear your reservations
about where the USD & thus, the price of gold, are heading
over the next few months to years. It's not a technical chart
but which argues for a weaker USD from a fundamental viewpoint.
I had drawn up this chart about
a month ago & had sent it to a few friends but it's still
valid since it's a long-term chart dating back from 1973. The
chart plots both the U.S. current account (red bar chart; left
scale) & USD Index (blue line chart; right scale) together
from 1973. By inversing the USD Index, we get a very good overview
at the relationship between the USD index & the current account
over this period.
We start by analyzing the period
between around March 1982 & March 1991, where the last "great"
USD adjustment took place. During this decade, both the current
account & USD Index marked out 3 distinct phases:
(1) Phase A. During the initial
period when the current account deficit first started growing,
the USD Index continued to strengthen. The USD Index only peaked
& begun weakening a few years later, approximately halfway
between the point where the current account deficit started to
the point where it peaked.
(2) Phase B. Some 2-1/2 years
after the USD Index started weakening, the current account deficit
peaked & began shrinking. At around the same time, the rate
of depreciation on the USD slowed down considerably as the market
begun to see the effect of the weaker USD work its way into the
current account. Notably, by this time, the USD had also weakened
back to the original point where it had strengthened from, a
few years back.
This lag between the time it
took for the weaker USD to translate into an improvement on the
current a/c deficit is caused by the J-curve effect - click.
(3) Phase C. However, despite
the improving current account deficit, the USD continued to weaken
albeit at a slower pace. This can be attributed to the overshooting
of the FX rate, a phenomena described by Dornbusch (for more
go here).
Fast forward to the present.
The USD is undergoing the three same phases we saw in the 1980s.
The current account began deteriorating
in the early 1990s. And as the case was in the 1980s, in the
initial years, the USD continued to strengthen regardless. 0nly
in early 2002 did the USD Index start to reverse its direction
(Phase A1). Since then, the current account deficit has continued
to weaken despite the weaker USD. We are now approaching Phase
B1 where the USD Index is moving back to the original starting
point from which it had begun i.e. around the 78/79 level. As
we are presently at around 87/88, & what this means is that
there is likely to be another 10% decline from present levels.
Little surprise here since the FX market is after all still targeting
EUR/USD at 1.35, for example.
Even when this continued decline
in the USD eventually translates into an improvement in the current
account, expect an overshooting in the USD Index. And judging
from the degree of overshooting we saw in the early 1990s, the
USD Index could reach anywhere between 50-70.
The above view that the USD
should continue to decline in the medium-term & in fact faces
the risk of overshooting, was echoed by the IMF when it said
in its World Economic Outlook Report
September 2003 (Chapter 1, pg 23).
"Despite its depreciation
over the last year, the dollar still appears overvalued from
a medium-term perspective, and the risk that its adjustment may
become disorderly - or that it might overshoot - cannot be ruled
out."
In summary, I draw two conclusions:
(a) It's very unlikely
that the USD's weakening trend has come to an end. The earliest
sign of this will be when the current account deficit stabilizes
& starts to improve over a 2 quarter period. Even then, there
is still a definite risk of the USD continuing to overshoot.
Personally, I believe that the magnitude of this current account
deficit coupled with the fact the U.S. faces an equally massive
budget deficit & consumer debt, the bias is towards a VERY
disorderly adjustment & a VERY serious overshooting. But
even if I am wrong & we get an orderly adjustment, the USD
& thus, gold, still has a long way to go in such an adjustment
process.
(b) Base on the 1980s experience,
the current account deficit stabilized some 2-1/2 years from
the start of the USD decline. Assuming this is the case this
time around, the earliest we will see the present current account
deficit stabilize is December 2004. However, with the current
account presently nearly 3 times that of that seen in the 1980s,
in all likelihood, the USD adjustment this time around will be
more severe in terms of magnitude & time taken.
Regards,
Sani Hamid
sani_hamid@email.com
February 2, 2004
Sani Hamid
presently works in Singapore for a London-based financial services
company & has over 10 years of experience in the markets
as an economist & currency analyst. He holds a Masters in
Applied Economics & is also a CFP™. He contributes this
article in his own capacity.
Copyright ©2003-2004
Sani Hamid. All Rights Reserved.
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321gold Inc Miami USA
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