Over the past month, the value of the US dollar has fallen significantly with the once mighty greenback dropping to a record low against the Euro and a 31 year low against the Canadian dollar. For currency traders, the dollar?s weakness has provided plenty of opportunities, but for the average person living in the United States, what does a weak dollar really mean? As there are two sides of every coin, a weak currency also has its advantages and disadvantages.
At a time when the US housing market is contracting, the job market is deteriorating and consumer spending is at risk, the US economy needs a weaker dollar. This is the primary reason why we do not expect the US government and the Federal Reserve to stand in the way of further dollar weakness.
Benefits of a Weaker Dollar
1) Increased Exports - One of the biggest reasons why a weaker dollar will help the US economy is because it increases the competitiveness of US goods. It boosts foreign demand while keeping US consumer demand domestic. Over the medium term, this benefits the sales of US corporations which will eventually translate into more jobs and consumer spending. It also helps to reduce the trade deficit, one of the most criticized aspects of the US economy.
2) Foreign Investment - There are three different ways that foreign investment can help the US economy and the US dollar. Over the past few years, foreigners have been big buyers of US real estate. According to a study by the National Association of Realtors, about one in five American real estate agents sold a second home in the year ending April 2007 to a foreign buyer. A third of these buyers come from Europe, a quarter from Asia and 16 percent from Latin America. As the US dollar continues to fall in lockstep with house prices, foreign buyers could provide the support that the US housing market needs to avoid a major crash. The second support would be in the form of value hunting in the US equity markets. If the dollar continues to fall, foreign investors may begin to load up on companies with sound fundamentals that are also less vulnerable to a US economic slowdown. Both of these factors are contingent upon the US dollar showing signs of stabilization. Foreign investors will only swoop in with size when they believe that dollar weakness is nearing an end. The third factor is less contingent upon the outlook for the US dollar. A weaker dollar also makes US corporations more attractive buyout targets. Sovereign wealth funds of countries like China and Dubai are flush with cash and are on the lookout for good investment opportunities.
3) Increased Tourism - Tourism represents a big part of the US economy. It supports employment for over 5.4 million workers and generates over $550 billion in annual revenue. Canadians represent the biggest group of travelers into the US. We expect their share to rise even further now that the Canadian dollar is trading at parity with the US dollar. In the beginning of this year, a USD$250 hotel room cost CAD$295, now it only costs CAD$250, which represent savings of over 15 percent. Although the savings for Europeans are not as large, they too will see anywhere between a 5 to 10 percent discount in travel costs. More tourism is always good for an economy.
Disadvantages of a Weaker Dollar
1) Higher Costs for Foreign Goods - The most immediate disadvantage of a weaker dollar is the increased costs for foreign goods. With a trade deficit of $59.2 billion, US consumers import far more than they export. The number one country that the US imports from is Canada, which is why the recent strength of the Canadian dollar is so important. Canadian drugs for example may not be as much of a bargain as they use to be. The same is true for European handbags and other luxury items.
2) Tighter Monetary Policy - Higher costs for foreign goods imports inflation which is why a weaker currency in general is inflationary. With oil prices hovering around $80 a barrel and the dollar falling through the floor, inflation is sure to pick up in the coming months. Martin Wolf of the Financial Times makes a fantastic point when he said that "The resolution of each crisis lays the seeds of the next." In order to get out of a crisis, the Federal Reserve will usually lower interest rates aggressively. We saw this after the Asian and Russian crises of 1997 and 1998. This eventually led to bubbles in the financial market, forcing the Fed to hike interest rates. Although inflation is not a huge problem at the moment, the threat of inflationary pressures could prevent the Fed from lowering rates as much as they would have otherwise wanted or needed.
3) Foreign Travel Becomes More Expensive - From a consumer level, the weakness of the US dollar makes foreign travel more expensive, particularly to countries like Europe and Australia. Since the beginning of the year, the Australian dollar has appreciated more than 10 percent against the US dollar. Because of nothing other than currency fluctuations, travel to Australia has become 10 percent more expensive. The same is true for travel to Europe except for the fact that the move is smaller on a percentage basis.
Can the US Dollar Fall Further?
The answer is yes. A trend in the currency market can last far longer than many people would otherwise expect. We have seen one way directional moves last for months and in some cases, even years. Interest rate outlooks play a major role in the future direction of currencies so with the market pricing in another 125bp of easing by the end of next year, the US dollar could easily fall to 1.50 against the Euro. This is especially true if the ECB remains nonchalant about the Euro?s move. At some point, the benefits of a weaker dollar such as increased exports and foreign investment will help to turn the US economy around, at which point the dollar will begin to rise once again.
What Does This Mean for Your Investments?
Regardless of whether you are actively involved in the currency market or monitor it at all, the value of the US dollar or currencies does matter. Companies that do a lot of foreign sales will benefit the most because their foreign currency revenue will be higher when repatriated not because they sold more goods, but because their earnings from currency conversion will be larger. The industries with the greatest foreign sales exposure are energy, technology and consumer staples. Companies that produce commodities usually also benefit from dollar weakness while the companies that will be hurt the most are big importers. If you have a view on where the US dollar is headed or want to hedge against some of your stock market exposure, the purest way to do so would be through trading or investing in the US dollar directly in the currency market.
By Kathy Lien, Chief Strategist of DailyFX.com