An annual IMF report on the US economic outlook highlighted deep concerns over the US current account deficit at records exceeding 4.0% of GDP. More disturbing was a claim by the IMF that the US dollar could be 20% above a medium term equilibrium level, although the analysis of such a claim was unavailable and will only come in a follow-up special topics paper. Purchasing power arguments and arguments that the euro is 20% undervalued are issues that could take years before correcting and values could move further away from medium term equilibrium levels in the meantime..
A first reaction to the IMF concern is that the current account has not been a significant factor behind dollar’s performance for several years, and now as the current account deficit is actually narrowing, highlighting the risks surrounding the high current account seems out of place. Yet the Current Account issue could become an issue if confidence on the US dollar is eroding which clearly it has in the short run..
The softening dollar in recent weeks can be tied to rising worries on 1) the timing of the US recovery, 2) mixed signals from the Bush administration regarding ? their strong-dollar policy, rising pressure from large US manufacturers including GM and Caterpillar, and concerns over US labor productivity that has undergone recent questions. On a trade weighted basis, the dollar is down 5.0% from its 15-year high set in late June. The bulk of that loss, however has been against the euro, where the dollar has fallen more than 7.0%. For European investors more heavily invested in the US equity and corporate debt, recent market performance and dollar performance have likely resulted in steep portfolio markdowns that could generate the very undesirable vicious circle of selling off US assets. At such a point, the large US current account deficit does become a problem. It is unlikely, however that the dollar sentiment will erode at such a pace. .
First, US productivity gains are real and were validated in recent benchmark revisions when Labor productivity posted a 3.1% gain in 2000, and regained productivity in Q2 at 2.5% after faltering temporarily in Q1 when it was flat. Stronger US productivity is the basis for higher returns and the lure for heavy inflow of foreign capital in recent years that caused the Current Account deficit to widen. Second, Yen may be the weak currency not the dollar. Recent reforms and most notably the new quantitative easing measures by the BoJ that will unleash more yen into the banking system is a weak yen story. Redeploying yen assets abroad are currently directed at a relatively cheap euro. A rising euro vs the yen is the larger issue and the dollar may be temporarily caught in cross action, providing enough of a reason to pull back from the 15-year highs. The weaker dollar vs the euro probably has more legs in the shortterm. .
The euro uplift likely to push higher in short-term, at least until the August 30 ECB meeting where odds of a rate cut are increasing, particularly in light lower inflation figures in France and further slippage in the growth outlook.
Market is increasingly sensitive to reports on dollar from IMF or US manufacturers and comments from Treasury Secretarty O’Niell have not been supportive this summer.