Will foreigners pull out?

If foreign investors become worried about capital loss on their investments caused by dollar deterioration, they could slow their investment inflows into U.S. capital markets.

“For European investors, even if the U.S. stock market goes up 5 percent, what if the dollar loses 10 - 15 percent?” Callow says.

Foreigners must first buy U.S. dollars to invest in U.S. capital markets and a continued retreat in the currency could discourage new foreign investment or even trigger some investors to cash out of U.S. trades. Bonds and stocks are vulnerable, Callow warns.

Because of the huge current account deficit, “the U.S. is reliant on the rest of the world to invest in it heavily every day,” he says.

Looking at recent data from the U.S. Treasury Department, foreign net purchases of U.S. Treasuries from January through September 2004 totaled $302 billion. From the first quarter 2004 total of $146 billion, however, a slowdown has already been seen. Third quarter purchases came in at $56 billion.

“That is a big thumbs down from foreign investors about how they see the U.S.,” Callow says. “There is plenty of evidence they are a lot cooler on it than they used to be.”

Taking a look at foreign investment in U.S. equity markets, the U.S. Treasury Department reported foreigners were actually net sellers of $2 billion in stocks from January to September 2004. That compares to $50 billion of equity purchases in 2002 and $38 billion in 2003.

“The world is a lot less inclined to invest in the U.S. than they used to be. Surely the dollar has played a role in that,” Callow says.

The danger, according to some market watchers, is that a continuing retreat in the dollar could accelerate U.S. inflation. That could trigger the Federal Reserve to increase interest rates faster than the market currently expects, in order to address inflation from a falling dollar.

“If China and Japan stop buying, it would push interest rates a lot higher and could hurt the economy very seriously,” Sloan concludes.