For most people the direction of the US dollar should matter. Whether the impact is direct (value of foreign holdings) or indirect (oil prices) it is important to understand where the US dollar is headed because of its effect on you. For me in particular it is important as I work/live in the US, travel overseas and have a significant part of my investment portfolio abroad.

Unfortunately over the last few years the dollar has been on a downward trend with little upward respite. The Dollar Index traded on ICE futures in New York, which tracks the dollar against currencies of our six largest trading partners has fallen over 15% in the past year. So is this down trend going to continue or will the dollar finally stand up and regain some of its lost value?

Before looking at the outlook for the US dollar, it is important to understand the key forces that drive currency movements.

Forces behind the dollar

Budget Deficit and Large import/export imbalance – The US runs a large budget deficit meaning that the value of our imports far exceeds that of our exports. To fund this deficit we need to continually sell US dollars to buy foreign currencies or repay debt. The increase in supply of US dollars to achieve this leads to a devaluation the currency. So as the deficit grows the dollar continues to weaken. A country like China on the other hand, exports significantly more than it imports. As a result, China will build up massive amounts of US dollars and US debt in its reserves (budget surplus) and will eventually sell dollars and buy other things (Euros, oil, gold) in order to diversify and get higher returns. As they sell their dollar holdings the US currency declines. Another factor driving the deficit is the tremendous cost to fund the wars in Iraq, Afghanistan and other places. As the country spends billions of dollars to maintain an overseas presence, we keep adding to our national debt and budget deficit.

Interest Rates and Economy– The fed has been aggressively lowering interest rates (and increasing the money supply) to keep the economy afloat after the sub prime and credit crisis. However the consequence of low interest rates and a faltering economy is that the US becomes much less attractive to foreign investors who can get larger risk free returns by putting money in higher interest rate counties like Australia and New Zealand (official interest rates there are around 7.5% compared to 3% here in the US). Lack of foreign investment in the US reduces demand for the dollar and results in the currency depreciating. This factor is probably the most influential in currency movements.

Speculation – This is when speculators bet that the economy, interest rate or other factors are going to continue to drive the US economy and currency down. This added pressure sets negative expectations and acts as an added (albeit unreal) force to keep the dollar down.

There are both benefits and drawbacks to a low US dollar. Our exporters become more competitive on a global level, companies overseas earnings are higher in US dollar terms and it helps the tourism industry. However we are currently being impacted much more by the negative effects of the lower dollar which has resulted in higher oil and commodity prices; and the continued erosion of the relative wealth of US residents in global terms. Worst of all it drives inflation as the cost of imported goods becomes more expensive.

See an updated article on the US dollar outlook here : US dollar update, outlook and opinions

What the experts are saying

Most experts are predicting the US dollar to stabilize over the medium term, but due to the above factors don't see any meaningful improvement in the near future. Here are some opinions from various sources:

Inflation is rising throughout the world due to dollar weakness, and the prices of such commodities as oil and corn have soared. The dollar has fallen 25% since 2002, and nearly 8% against the euro so far this year. As former Federal Reserve Chairman Paul Volcker noted last week, we are already in a "dollar crisis." Even the International Monetary Fund – typically the temple of devaluationists – is alarmed by the dollar's fall.

``The dollar has been coming under pressure versus the euro lately, which could be the start of a new trend,'' said Neil Mellor, a currency strategist at Bank of New York Mellon Corp. in London. ``The euro is being buoyed by the continued hawkishness of the European Central Bank.'' (Bloomberg.com)

"Look for the U.S. dollar to head toward its low against the euro this week if rising crude-oil prices fuel more concerns of a general rise in U.S. inflation. Inflation, always a gauge of a currency's value, has become an even bigger factor in foreign-exchange markets as investors fret over soaring oil prices and the implications beyond the cost
of gasoline." (Wsj.com)

"As the dollar's fortunes have become increasingly tied to inflation concerns...a firm break to the downside in oil prices will be needed to help the dollar find the momentum to strengthen," said Manuel Oliveri, a currency strategist at UBS.

There is a scenario in which a spike in U.S. inflation could help the dollar. Prices could rise so dramatically that the U.S. Federal Reserve would feel the need to shift its focus away from cutting interest rates to boost the economy and would instead put its attention on fighting inflation. Any signs of such a shift would lead to expectations that the Fed might start raising interest rates. Such expectations could boost returns on dollar-based investments, which would bring many investors back to the dollar. (Wsj.com)

"The dollar will keep sliding amid the slowing U.S. economy,'' said Michiyoshi Kato, a senior vice president of currency sales in Tokyo at Mizuho Corporate Bank Ltd. "Weaker data will force the Federal Reserve to lower interest rates further.'' We expect the dollar to remain under selling pressure as market participants' optimism over a notable upturn in economic activity gradually fades,'' wrote Derek Halpenny, head of currency research at Bank of Tokyo-Mitsubishi in London

"The Fed is telling us to not think in terms of easing [lowering interest rates],'' said Alan Ruskin, head of international currency strategy at RBS Greenwich Capital Markets. "That is the most important feature behind the dollar comeback....''

In conclusion and my opinion

From my research and reading the outlook for the dollar looks quite bleak over the next year due to various economic pressures. However as the economy starts recovering and the federal reserve starts tightening monetary policy (raising interest rates) the US dollar will start appreciating. This should start happening towards the end of this year and my view is that by the end of 2009 the dollar should be up 15-25% from current levels. As the US dollar, or greenback as it is called, recovers along with the economy we should see lower inflation and higher house prices. Best of all, oil and gas prices should start to fall as well.

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US dollar update, outlook and opinions