The relationship
between the dollar & the current account
Steve Saville
Apr 5, 2004
Below is an extract from
a commentary posted at www.speculative-investor.com on 4th April
2004.
Everybody knows that the US$
has been under pressure over the past two years as a result of
the US's huge current account deficit. It is often the case,
though, that what everybody knows is either not worth knowing
or is just plain wrong. In this case, it's mostly wrong.
The huge current account deficit being run by the US is certainly
important to the LONG-TERM bearish case against the US$. Furthermore,
a good argument can be made that the US$ will continue to decline
until the quarterly current account deficit is reduced to zero
(this is an argument we've made in the past and that we continue
to think is valid). However, the following chart comparison of
the trade-weighted exchange index of the US$ and the quarterly
US current account balance indicates that the current account
deficit has NOT been the primary driver of the Dollar's bear
market to date. Note, in particular, that the deficit grew from
$25B to $100B between 1995 and 2001 while the dollar trended
HIGHER and has only increased by a relatively small amount since
the dollar began to trend lower. It could obviously be argued
that an increase in the current account deficit over many years
created a build-up of pressure that eventually tipped the US$
over during the first quarter of 2002, but such an argument would
miss a very important point. The point is: something changed
during 2001-2002 that suddenly made the current account deficit
MATTER and it is this "something" that has been the
primary driver of the dollar's bear market, not the current account
deficit itself.
The two shaded areas on the
above chart identify the two most recent cyclical bear markets
for the US$, the latest of which is on-going. In our opinion,
the current bear market will continue until the quarterly current
account deficit has been eliminated just as the bear market that
began in 1985 continued until the current account deficit was
finally reduced to zero in early 1991. However, the chart shows
that there is no correlation between the performances of the
dollar and the current account balance during any given year
and that the dollar can move sharply higher in the face of a
deteriorating current account situation. It is therefore nowhere
near enough to simply recognise what is happening with the current
account balance (the current account balance is just a number
that is reported four times per year and is information that
every market participant knows). Instead, in order to have a
good chance of being right about where the dollar is headed over
the coming 1-2 years it is necessary to understand a) what changes
occurred in 2001-2002 to make the US current account deficit
matter, and b) whether or not these changes are likely to remain
in effect.
The level of investment demand for dollar-denominated assets
and debt determines how the dollar responds to a current account
deficit and the reason that the increase in this deficit didn't
seem to matter prior to 2002 was that the foreign investment
demand for dollars was increasing at a faster rate. In other
words, the thing that changed in the early part of 2002 was that
the investment demand for dollars began to wane.
The investment demand for dollars is determined by things like
nominal interest rates and expected stock-market returns in the
US relative to the interest rates and stock-market returns available
in other parts of the world. An important determinant of investment
demand is also the expected future level of inflation, because
investors are primarily concerned with real (inflation-adjusted)
returns. This is, of course, why representatives of the Fed spend
so much time and effort talking-down the prospects of a US inflation
problem and why the US Government goes to the trouble of reporting
producer price indices that are so obviously wrong. It's all
about creating the illusion that nominal returns are real.
Further to the above, we expect the US$ to fall further before
the first major bottom of its long-term bear market is put in
place; not because of the large US current account deficit but
because we don't see much chance of dollar-denominated assets
and debt offering foreign investors enough relative value. Specifically,
the US stock market does not look attractive relative to many
other markets around the world, nominal interest rates in the
US are too low, and the US inflation problem is unlikely to remain
under wraps for much longer. The current account deficit is part
of the equation, but only to the extent that if the US was not
running a large current account deficit it wouldn't need to attract
so much new investment each month and the real returns offered
by dollar-denominated investments wouldn't be as critical.
 Steve
Saville
email: sas888_hk@yahoo.com
Hong Kong
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