Is the US dollar about to reverse course?

For the first time in several years, the US dollar has managed to gain value against the other major currencies of the world. During the first three months of 2005, the US dollar rose about five percent against both the yen and the euro. The dollar’s gains should be considered significant when considering that the US continues to face a growing trade imbalance. So far this year, currency traders have shifted their focus from large US trade and current account deficits towards higher rates of returns offered on US debt. The recent strength of the dollar has changed sentiment in financial markets about the future direction of the currency. A Bloomberg survey earlier this week showed that major currency traders expect dollar weakness to resume later in the year, but sentiment between the bears and the dollar is much weaker than it was at the start of the year.

The strength shown in the US currency so far in 2005 is supposed to be short-lived. The robust GDP growth over the past 18 months will begin to show signs of approaching more normal levels over the next two months. Signs of slowing economic growth are likely to cause a shift in sentiment among currency traders towards the fundamental problems facing the US economy. The US trade and current account deficits show no signs of abating anytime soon. In fact, we expect the upcoming trade numbers to show a further deterioration in the trade balance over the next few months. Major industrialized nations outside the United States continue to experience weak economic growth. This continues to put more pressure on the US dollar as the US consumer continues to purchase goods produced in Europe, Japan and China.

While we expect the dollar to resume its gradual decline against most major currencies, the main wildcard in our forecast is of course China. Recent information from China’s top decision makers indicates that the Chinese are in no hurry to adjust the current value of the yuan-dollar relationship. Should any talks emerge of a possible revaluation later in the year, the downward pressure on the US dollar will accelerate as currency traders will buy the Japanese yen and other freely traded Asian currencies, which will likely benefit from the revaluation.