>What’s Wrong with the Dollar? (WELLS FARGO)

Executive Summary
The dollar has followed a downward trend over the past six months, weakening against the currencies of other major economies and developing countries alike. Some observers claim that the dollar’s depreciation reflects unease among foreigners about the U.S. fiscal outlook. However, there is very little evidence to support this hypothesis. Purchases of long-term U.S. Treasury securities by private foreign investors and foreign central banks have remained strong during the recent period of dollar weakness.

Rather, the depreciation of the greenback reflects, at least in part, an unwinding of the forces that propelled it higher last autumn. As the global financial system stood on the cusp of collapse, foreign purchases of short-term Treasury bills, considered by many to be the safest asset in the world, surged. In addition, foreign banks had to scramble for dollar liquidity as U.S. banks pared back their credit lines. Now that the global financial system has stabilized, net foreign purchases of low-yielding Treasury bills have weakened considerably as investors have gone in search of higher returns. In addition, American banks have started to reopen some credit lines to their foreign counterparts.

What could cause the dollar to turn around? Another increase in risk aversion likely would cause the greenback to strengthen, but even the most fervent dollar bull probably would blanch at the thought of another financial market meltdown. The dollar’s best, and less psychologically stressful, hope probably lies in a truly self-sustaining U.S. economic recovery. A run of better-than-expected U.S. economic data would lift rates of return in the United States that would attract long-term capital inflows.

Greenback Resumes Its Slide
After rising to a three-year high earlier this year, the trade-weighted value of the dollar has slid over the past few months (Figure 1). Not only has the greenback weakened against most major currencies—it has dropped to a 12-month low vis-à-vis the euro—but the dollar has also depreciated versus the currencies of many developing economies. Predictably, the financial press has been filled with renewed prognostications of the greenback’s ultimate demise. A theory that has gained currency among some observers recently is that the weakness of the dollar since the beginning of the year reflects concerns among foreign central banks and foreign investors about the gaping federal deficit and/or fears of runaway inflation. Does this theory have any merit? If not, why is the dollar weakening again?

To make sense of the dollar’s depreciation over the past few months we examine the U.S. balance of payments data, which measure transactions of U.S. residents with the rest of the world. We begin with the current account, which records transactions of goods and services.1 After narrowing sharply late last year and early this year, the U.S. trade deficit has been essentiallystable since March (Figure 2). Therefore, it is hard to make a convincing case that the dollar’s depreciation over the past few months is linked solely to a renewed deterioration in the U.S. trade position with the rest of the world.

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