Weak US dollar balancing on trade tightrope

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A weakening dollar may be just what the US economy needs to limp through a housing downturn without tumbling into a full-blown recession.
The tricky part is striking the right balance between spurring export demand, which bolsters US economic growth, and maintaining sufficient interest from foreign investors, whose purchases of US assets finance a gaping US current account deficit. For currency traders, the Federal Reserve's decision on Tuesday to lower benchmark US interest rates by a surprisingly steep half-percentage point has meant open season on the dollar, which plunged to an all-time low against the euro and fell sharply against most other major currencies.
That bodes well for exports, which in theory should become more affordable to buyers overseas. But investors and economists are warily watching a handful of key foreign exchange rates - particularly the euro's - for any sign that a weak dollar is doing more harm than good. Exports accounted for a third of the 4 percent rise in second-quarter US gross domestic product and should continue to contribute strongly, judging from recent trade data showing exports grew nearly three times as fast as imports in the first seven months of 2007. "A lower dollar is a big benefit," said Andrew Busch, global foreign-exchange strategist with BMO Capital Markets in Chicago. "It pumps up GDP by around 0.5 (percentage point) per quarter and offsets half of the losses from the housing sector." But with oil prices at record highs, a drastically weaker dollar raises fresh fears about inflation, particularly among the army of foreign bondholders who provide crucial financing for the trade gap, which amounts to 6 percent of GDP. The Fed's move on Wednesday dragged the federal funds rate to within just 75 basis points of benchmark euro-zone rates. That diminishes the appeal of dollar-denominated assets, especially at a time when the European Central Bank continues to dwell on price pressures, suggesting it may raise rates again this year.
Fleeing long-term securities: Just before the Fed's rate decision, a worrisome sign came from the US Treasury, which reported net foreign purchases of long-term US securities hit a seven-month low in July. And because the data covers inflows before August, when losses on bonds tied to risky US mortgages intensified a global credit squeeze, the next batch may be even worse.
Nouriel Roubini, a professor at New York University's Stern School of Business and head of Roubini Global Economics, said fear of a US recession may prompt the Fed to cut rates again, heaping more downward pressure on the dollar. As a net debtor, the US government must attract some $3 billion every working day to finance its current account deficit, the biggest part of which is the trade deficit.
Since US consumers spend more than they save, that money must come from foreigners - either private investors or central banks looking to recycle currency reserves. Since late 2005, the euro has gained about 16 percent on the dollar, climbing from around $1.18 to an all-time high this week at $1.3988. If the dollar continues to move lower, "the risk of a disorderly fall becomes larger, and unless central banks step up purchases even more, the dollar could be in trouble," Roubini said. Longer term, the fear is that a weaker dollar would push up import prices and inflation and cause long-term interest rates to rise, squeezing the US consumer.
Indeed, the Fed's move on Wednesday steepened the Treasury yield curve, with yields on shorter-dated bills falling while yields at the long end pushed higher. Some economists have said a sustained move above $1.40 would threaten euro-zone exports and could push the economy into recession. Roubini calls a euro exchange rate in the $1.40-$1.45 area "a natural tipping point." Many European economists also see that level as a worry. According to a Reuters poll released on Wednesday, economists think the euro at $1.45 would be a major concern to finance ministers.
Ironically, though, some say market turbulence may be good for the dollar as skittish global investors seek safety in US assets. Despite worries about a slumping housing market slowing growth, the United States still boasts the world's deepest capital markets and remains a safe haven in times of trouble. — Reuters