Beans: The Dollar to Fall Again in 2006?

The perhaps most surprising economic development in 2005 was the fact that the dollar rose sharply against most mayor currencies, contrary to the expectations of most economic analysts -including me- that it would continue to fall.

The mistake we made was underestimating the effect interest rate differentials would have and as American interest rates rose sharply relative to those in Europe and Japan, it led to dollar strenghtening, despite the large and rising current account deficit and the higher inflation in America. The dollar rose from 103 to 121 yen and $1.17 against the euro versus $1.38 the year before (Note: as the euro is higher valued than the dollar a lower number means a stronger dollar).

In the first days of 2006, the dollar have fallen back somewhat against both the euro and the yen, with the latest number being 114.3 against the yen and 1.216 against the euro. This was largely the result of Fed minutes showing that the series of "measured" rate hikes will end sooner than most people thought.

What will happen to the dollar in 2006? While I and all others who have tried to forecast exchange rate movements have learned that certainty is unattainable with regards to future currency movements, it is still possible to say what is more likely than not given the available data.

It seems to me more likely than not that the dollar gains of 2005 will continue to reverse. In 2005, the large current account deficit was more than compensated by the large capital inflow generated by the higher interest rates. Yet with the yield curve turning negative, the Fed will probably not dare raise much more. Just when they will stop depends of course on how strong or how weak the U.S. economy will be. With some indicators pointing to a sharp slowdown and even a recession and with others pointing to continued expansion, the outlook is more uncertain than ever. The most likely scenario given the high corporate profits and rising stock prices countered by a negative household savings rate and a slowing housing boom is slower but still positive growth, although both strong growth and a sharper slowdown cannot be ruled out.

However, provided the U.S. economy does not surprise on the upside, U.S. interest rates will probably peak very soon at a level lower than 5%. At that point, concern over the U.S. current account deficit which is moving towards 7% of GDP , will probably be increasingly the focus of capital markets.

Meanwhile, the cyclical indicators from the Euro-zone are more consistent than in America and they all indicate that the Euro-zone have entered a cyclical recovery which probably will embolden the ECB to continue raising interest rates, narrowing the interest rate spread.

Cyclical indicators from most other countries including China and Japan also indicate fairly consistently a global cyclical recovery. The big exception -apart from the U.S.- is Britain which have seen growth slow considerably as the slowing housing boom have made the highly indebted British households reluctant to spend. As a result, Britain looks likely to have slower growth than the Euro-zone in 2006 for the first time since the euro was launched in 1999. Because of this, the Bank of England will certainly not raise interest rates, they will more likely be lowered.

Because of all this, the dollar and the pound will probably -again barring a stronger than expected economies in the US and the UK- lose ground this year, while the euro along with last years big losers in the currency markets, the yen and the Swedish krona will probably stage a comeback. China will continue to gradually raise the value of the yuan relative to the dollar in order to defuse the increasing anger in Washington D.C. over its currency policy . And gold will likely also continue to rise-at least against the dollar.

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