As the US Dollar seemingly becomes more globally despised with each passing day…investors are growing increasingly nervous about a possible collapse in the “good old greenback.” The Dollar has fallen over 8% against the Euro during the past three months alone. The primary fear among investors is a scenario where a steep and prolonged depreciation of the Dollar would trigger a rush among foreign investors to exit from the US financial markets. This mass exodus would set off a drop in both the stock and bond markets, and trigger a spike in US interest rates.

How did the Dollar get in trouble? Let’s take a look back.

Many analysts trace the Dollar’s current woes to the United States’ problem of enormous and growing "twin deficits”, the current account deficit and the federal budget deficit. The current account deficit or “trade deficit” is at record levels with no signs of a reversal. In fact, the US currently needs more than $1.5 billion in daily foreign inflows, just to prevent the Dollar from depreciating any further, purely based upon trade. Meanwhile, the federal budget deficit also hit all time highs in 2003 and 2004 due to the recession and the war on terrorism.

Now, let’s go a bit deeper. Most people are familiar with the federal budget deficit…but perhaps not as much so with the current account deficit. So just what is this “current account”? The US current account is a record of bookkeeping for all the international transactions between the US and the rest of the world. The current account balance is made up of the following elements:

• The balance of trade, which is the net difference between merchandise exports and imports, such as vehicles and clothing. The balance of trade is the largest and most widely reported element of the current account balance, and is also an element of the GDP. A merchandise trade deficit occurs when a country’s imports exceed their exports, and is subtracted from the GDP. Conversely, a merchandise trade surplus occurs when a country's exports exceed their imports, and is then added to the GDP. The US has had a merchandise trade deficit each year since 1975.
• The net difference between services exports and imports. For example, when a foreign tourist spends money on a hotel room and on restaurant meals while visiting the US, this is considered an export of services from the US. This is a smaller element of the current account balance, and the US usually runs a surplus in the trade of services.
• The net difference between income flowing into the US from US-owned assets in foreign countries, and income flowing out of the US from foreign-owned assets in the US.
• The net difference between inflows and outflows of “unilateral transfers” such as foreign aid and charitable gifts. The US presently provides massive amounts of foreign aid to other countries.

All these factors combined…the US current account is presently showing a deficit, predominantly because of the large US merchandise trade deficit. How does the account become balanced? Obviously, one way would be to reduce the massive trade deficit, currently approaching $600 Billion. Another way is to offset the deficit with a capital account surplus. A capital account surplus occurs when foreign purchases of US Dollar denominated assets such as stocks, bonds, and real estate exceed US purchases of foreign assets.

And what does all this have to do with the price of tea in China? Actually quite a bit.

Remember that the weak US Dollar means that our domestic products are cheaper for foreign buyers, and conversely, foreign products become more costly for Americans. This imbalance hurts the already fragile economies in many countries abroad, while helping US exporters. The natural inclination on the part of foreign central banks is to respond with “intervention”, which is the purchase of US Dollar-denominated Bond instruments – like Treasuries and Mortgage Bonds – in an effort to slow down the decline of the US Dollar. There is talk that the critical currency exchange levels that would trigger intervention are around $1.40 for one Euro and 100 Yen to the Dollar. Should intervention take place, expect a short-term rally in Bond prices, and improvement in home loan rates.

But financial market fears over the current account have grown, and there is increased awareness that the US government is secretly happy to see a gradual decline in the Dollar, which helps to ease these trade imbalances. Treasury Secretary John Snow has publicly repeated a stand on a strong Dollar policy, but the currency markets are increasingly skeptical. The Treasury is not in a position to publicly change its stance – as this would seriously damage Dollar confidence – but the markets are starting to assume the Treasury is comfortable with a gradual depreciation. The Federal Reserve has voiced concern over the current account position as well. Fed Chairman Greenspan was surprisingly candid at the recent G20 Summit, where he warned that intervention was just a short-term fix, and foreign enthusiasm for Dollar-denominated assets would eventually fade.

Now knowing that a capital account surplus will help offset the deficit and slow the decline of the Dollar…what’s the latest with foreign capital flows into US Dollar denominated assets? The recent foreign capital flows data was stronger than expected, with inflows of $63.4 billion for September compared with $59.9 billion the previous month. There had been some forecasts predicting a decline in inflows to $25 billion or lower…and the fact that the Dollar failed to strengthen, even after foreign capital inflows greatly exceeded estimates, strongly indicates the current level of negative sentiment towards the US Dollar.

So what happens next?

In the months to come, there will be increasing concern voiced by foreign governments that in an effort to help ease the current account deficit, the US is ignoring the steady decline in the Dollar. Yet in the short term, there is very little likelihood that the US will intervene to stem Dollar losses. They would likely step in only if the currency markets become disorderly, or if the stock and bond markets start to weaken sharply. Recent US economic growth data has been favorable, and there is a high probability that short-term interest rates will increase by another 25 basis points during the December FOMC meeting. Higher debt yields will help to provide some support for the Dollar, but the overall trend still looks to be for further depreciation.

Some points of interest:

• A weaker Dollar makes US goods more affordable in overseas markets.
• From a foreign investor standpoint, a weak Dollar reduces the value of US investments, making them less attractive to own.
• Foreign countries own about $1.3 trillion in US Bonds and Securities.
• A decline in the value of US Dollar denominated investments could eventually lead foreign investors to demand higher interest rates, or even prompt them to stop buying them altogether…and start selling them off.
• It is widely recognized by economists that the most effective way to narrow the trade deficit and the current account imbalance is to reduce the massive US budget deficit. This would reduce the need for Uncle Sam to issue so many Treasury notes. With a reduction in Treasury note supply, the Dollar would rise on its own because the deficit is the main reason it continues to decline.
• The United States' bid to solve its current account problems by keeping the Dollar weak could affect the world economic growth.
• Many economists and the US multinational corporations that see the bulk of their profits from exports say Dollar depreciation is inevitable, and even desirable, after a sharp run higher in the Dollar a few years ago. However, a weaker Dollar could trigger rising inflation and force the Federal Reserve to raise US interest rates faster than it wants to, thus curbing consumer spending and risking a new downturn in the economy.
  
• Weakness of the US Dollar could trigger a financial crisis against the backdrop of prevailing high oil and commodities prices. The capital flow, which resulted from currency depreciation, will again lead to the fall in the Dollar's value.
• Rapid weakening of the Dollar will dampen the economy as most investors have stocked up on Dollar-denominated debt instruments (Bonds). The Dollar is also the key currency among international trading partners.
• As the current account deficit problem continues, the United States has become the world's largest debtor nation owing a total of 2.5 trillion Dollars.

Here’s the bottom line.

The Dollar’s recent slide is a very complex topic, and many of the smartest and most powerful minds and government bodies in the world are perplexed on how to best handle this critical issue. In the end, it will be the financial markets themselves that will find equilibrium. However – it should be noted that as financial markets seek this equilibrium, they typically initially overshoot the mark. In this case, the Dollar may slide to a dramatic level before recovering into a range that is most acceptable to the markets. The consequences of the mark being overshot – and by how much – will be interesting to watch.