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The U.S. dollar has remained strong in the face of an ever-deepening global economic crisis, as investors have flocked to the safe haven of the reserve currency. But don't be deceived by the dollar's recent strength. The "honeymoon" for the greenback could be ending soon, according to Andy Busch, global foreign exchange strategist for BMO Capital Markets.
"I expect [the dollar] to weaken dramatically by the end of the year," Busch said in an interview. "It's going to be a tale of two 'years'. "
For now, Busch expects investors to keep buying U.S. Treasury securities, which will keep demand for the dollar strong. He also says that strong participation in the Treasury's and Federal Reserve's programs and backstopping of new securities will boost the dollar. Additionally, entities like AIG (NYSE: AIG ) , which are selling assets abroad to raise capital and then funneling the capital back into the United States, will cause the dollar to retain its value.
Fast-forward to the second half of 2009, though, and Busch says he expects the dollar's strength to reverse, as conditions stabilize and a glimmer of improvement in the economy surfaces. "I would argue that the second half of this year will be dominated by two very important themes: one, a massive fiscal deficit, and two, the quantitative easing that's being done by the Federal Reserve," he said. "Both lead me to believe that the dollar is going to weaken significantly in the second half of this year."
As these themes take hold, Busch expects a 15% to 20% drop against the euro from the dollar's first-half highs. Against the yen, he suggests the dollar will most likely trade sideways, as the yen has already strengthened so much against other currencies. He also points out that the Japanese are dissatisfied with the yen's recent appreciation, and as a result sees at most a gain of 5%. Similarly, Busch expects the British pound to recover from its dramatic sell-off, but only by roughly 5%.
2010 and beyond
Looking down the road several years, Busch says the dollar's problems will persist. "I think we will revert back to the problems in the U.S. that we were looking at prior to the summer of 2007," he said. "The structural problems are still there. If the economy stabilizes and oil starts to go back up, we're going to see the trade deficit start to go back up. That poses a severe problem for the U.S. to have those twin deficits that could expand exponentially."
Busch says we run the risk of devaluing U.S. currency dramatically by pursuing expansionist economic policies. He points to examples in history for what happens to struggling countries that implement such policies:
Every time they decide to expand their budget deficits, it spells disaster. I think a great example of this type of discussion is Kenneth Rogoff's open letter to Joseph Stiglitz back in 2002 on this specific question over criticism on the IMF. Stiglitz and Krugman are heavy advocates of Keynesian economics and issuing more debt to help economies pull out of their stupor. During the 1997 currency crisis, the IMF came under heavy criticism for pursuing improved fiscal deficits and raising taxes because it slowed down the economies. Therefore, history proves that when you expand you run the risk of having great problems down the road.
The dollar and global trade
With every country around the globe facing a slowing or shrinking economy, a new resurgence of protectionism begs the question of whether the tactics the government is using to combat this protracted recession will support the dollar. Busch points to history for clues. After equity markets crashed in 1914 following a period a rapid global expansion, international trade stalled for 60 years after countries adopted protectionist measures.
Despite the looming threat to trade, Busch says the dollar "remains the facilitator of global trade. … The key question is whether or not entities such as Japan and China are going to continue to accumulate massive reserves on the U.S. dollar going forward." The U.S. policy stance on China's currency was brought into the limelight when Treasury Secretary Timothy Geithner accused the Chinese of currency manipulation.
"Going forward, the structures that had previously been in place due to the massive accumulation on these reserves is going to be questioned more and more," he said. "Though the dollar will remain a key currency for reserves, people certainly realize now the risk of accumulating such large reserves and the risk to a one-sided portfolio that's out there."
Fool's final word: What the dollar means for your investments
The dollar's strength has recently weighed on the bottom lines of companies that earn much of their revenue abroad, such as Deere (NYSE: DE ) , PepsiCo (NYSE: PEP ) , and Caterpillar (NYSE: CAT ) . Coca-Cola (NYSE: KO ) , for example, saw its operating income fall 9% in the fourth quarter due to a stronger dollar.
In addition to watering down overseas profits, a strong dollar also puts companies in a difficult position. Raising prices to make up for negative currency effects can cut already tapered demand for products, especially in a recession.
Conversely, if the dollar reverses course and heads south, as Busch expects, it could be a welcome ray of sunshine for companies with substantial overseas exposure. Businesses like IBM (NYSE: IBM ) or Intel (Nasdaq: INTC ) could see higher earnings that would offset economic weakness at home.
Granted, the world economy is slowing, and as a result, so could global consumption. But look closely at a company's financial reports to gauge its exposure to overseas markets. If ever there were a silver lining for companies in this situation, the falling dollar could be one.