Factors driving dollar valuations

The confidence of global and domestic market participants could be compromised by several factors. Oil prices and core inflation continue to be significant risk factors that could weaken global markets.

A shift in competitive foreign markets should also be monitored. The U.S. has long been the global leader in information technology (IT), as our culture and economy are conducive to innovation, capital formation and free market competition.

Lately, however, there has been considerable media and market focus on growing forces of foreign competition. America’s general dominance in IT and the services sector is being challenged by emerging technology suppliers such as Singapore and Taiwan, as well as outsourcing destinations
like India. BusinessWeek reported (“The Promise: Global Brain Power,” Oct. 11, 2004) U.S. investment in research and development of 2.7 percent of GDP was outpaced in 2003 by two thriving innovation hotbeds: South Korea (2.9 percent of GDP) and Israel (4.7 percent of GDP).

These and other countries are becoming major contenders in the race to supply the lucrative global computer and telecommunications networking industries.

In the currency market, traders question the long-term outlook for the dollar given the rise of the euro as a major currency, and the opening of new financial markets. For instance, in an effort to develop its capital markets, China is planning to ease restrictions on foreign investments and exchange (Bloomberg, “To Rally Stocks, China Moves to Ease Foreign Trading Rules,” Sept. 23, 2004). Relaxed capital controls and the formalization of Chinese financial market rules will be key to building global confidence in that market as it matures. However, the magnetic appeal of U.S. markets remains
strong. Unfazed by such jolts as widespread U.S. financial market improprieties in recent years, foreigners continue to entrust their capital to the world’s largest and most secure marketplace. The ongoing recovery and stability of U.S. financial and trade markets is another prerequisite for continued
strength in the USD.

Employment growth will support the dollar, while the reverse is also true. U.S. consumer spending has risen steadily even through the recession, despite such setbacks as investor fears in the wake of the terrorist attacks and following high-profile accounting scandals. With nearly 70 percent of GDP driven by consumers, their ability to spend is a critical driver of currency and broader markets. Continued disappointments in job reports, as in early October, would have a tempering effect. If capital flows are attracted elsewhere and foreigners become reluctant to invest sufficiently in the U.S. to fund
our national deficits, U.S. interest rates must rise to attract foreign funds, and the dollar must fall to make the purchase of U.S. assets and exports more attractive. If interest rates rise, the amount owed to foreign investors for their dollar denominated holdings will rise, adding to the deficit, whichmust be financed.