Temporal rift

While we should be prepared for a weaker dollar in the near-term, the downtrend is getting a little long in the tooth as 2007 draws to a close. In terms of duration and magnitude, the downtrend does not seem exceptional, but market participants often underestimate cyclical influences and exaggerate structural influences.

Traders should not make this error with the dollar. Many foreign currencies, such as the euro, sterling, and Canadian dollars, are well beyond levels that reasonable valuation models would suggest are appropriate. As the late free-market economist Rudi Dornbusch taught us, an overshoot in the foreign exchange market is perfectly rational, but it is still an overshoot.

In the short-run, the U.S. dollar was punished for the Federal Reserve’s pro-growth policies of interest rate cuts. Depending on a number of imponderables, the other major economies may be four-nine months behind the U.S. easing policy, except perhaps the Japanese. The Bank of England and the Bank of Canada are the most likely candidates to follow the Fed, while, in contrast, the Reserve Bank of Australia and the Riksbank of Sweden might not be finished tightening yet.

Policy makers abroad will need to respond to several headwinds; many European countries already appeared to be losing economic momentum even before the credit crunch took hold. While the U.S. economy accelerated in Q2 and Q3, Europe slowed and Japan actually contracted in Q2, although it recovered somewhat in Q3.

The tightening market conditions, the appreciation of the euro and the pound, and the rise in energy prices will take their toll. Individually, these challenges may not seem significant, but together they are likely to trigger a policy response. By that time the Federal Reserve will be done (or nearly done) tightening and the groundwork for the U.S. dollar’s cyclical recovery could begin.

A year from now, maybe we will be talking about “eurosclerosis” and America’s amazing ability to reinvent itself.