What's Going On with the Dollar?

Amidst all the volatility in the stock market, there have been equally wild moves in the currency markets.  The dollar has been in general decline since 2002, but that has reversed dramatically in the last month.  As measured by the broad trade-weighted index, it fell from over 130 in early 2002, to under 100 a month ago, and now stands at over 110.  

Similar percentage moves are seen if one just looks at the movement of the dollar relative to major currencies, from an index level of almost 112 in early 2002 down to under 74 a month ago back up to almost 84 now.  The only currency that has bucked this trend recently is the Yen, which has dramatically strengthened versus the dollar in the last month, moving to under 94 yen to the dollar from over 107 a month ago (and almost 135 back in early 2002).  

What is going on?  The U.S. is the epicenter of this latest financial earthquake, so why should the dollar be doing so well against everything except the Japanese currency?  Are the fundamentals of the U.S. economy that much stronger than the rest of the world?  Is Japan in that much better shape than we are?  

The answer seems to be the unwinding of the carry trade.  With its extremely low interest rates, it made sense for people to borrow in yen and lend in other currencies at much higher rates.  This was particularly true of emerging markets, but was also true of the Euro zone and Australia.  Now with every bank in the world wanting its money back (in the currency they lent it out in), those that borrowed in low interest rate currencies like the yen and the dollar are in a deep fix.  

Most international loans are made in dollars, so there is a big demand for dollars to repay those loans.  The yen was the original source of funds for many of these loans, so there is an even bigger demand for yen.  In a sense, we are seeing a repeat of the 1997 Thai "Baht-ulism" experience, only this time it is not contained to a single region -- it is in all the major emerging markets (China to a much less extent than others).  

European banks seem to be particularly exposed to this effect in Eastern Europe, this time around.  Back in '97, it was more that government loans and the emerging market central banks did not have a lot of reserves.  Now, the emerging market central banks are generally holding much more significant foreign exchange reserves, but many of the private banks are very exposed to this inter-currency lending.

The rapid strengthening of the dollar is going to have a double-barreled effect on corporate profits.  The most immediate is going to be seen through the translation effect.  The profits earned abroad in Euros, Pounds or Rupees are simply worth less than they were when translated back into dollars.  There might be a little bit of this effect showing up in the third quarter numbers, but if exchange rates stay where they are or the trends continue, it will have a much bigger effect on the fourth quarter.  

The second effect is a loss of U.S. competitiveness.   A widget made in the U.S. now costs more than a widget made in Germany or France, which should cause U.S. widget makers to lose market share.  Given that the world economy is slowing dramatically (and this currency crisis will slow it still further) we are now talking about a shrinking share of a shrinking pie.  Big-ticket capital goods exporters like Caterpillar (CAT - Analyst Report), Deere (DE - Analyst Report) and Boeing (BA - Analyst Report) could be particularly exposed to this.

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