The U.S. dollar has weakened against the major currencies in recent weeks, and many analysts are extrapolating a significant decline in the greenback. Chances are, though, the weakness will prove temporary, once again.
Traders are selling the dollar primarily because they have begun to digest the reality of a U.S. slowdown, which was widely doubted only a few weeks ago.
The collapse in U.S. housing is proving to be bigger than anyone bargained for, and the risk of spillovers onto the rest of the economy is growing.
This is fuelling speculation that the Federal Reserve will be cutting interest rates sooner rather than later, which could be a legitimate reason to expect the dollar to decline.
But this story also assumes that growth in Europe and Japan will be resilient to the U.S. slowdown, so that interest rates in those countries remain unchanged or rise as U.S. rates fall. Such unsynchronized growth would be unusual, to say the least, and would defy other evidence of globalization.
Some even believe that growth in Europe and Japan can increase, keeping global growth steady. However, the arithmetic suggests that this would be quite a stretch.
Keeping global growth steady in 2007 in the face of a slowdown in U.S. growth to around 2.2 per cent would require that growth in Europe and Japan increase to three per cent or better.
In both cases, this would put growth well above the economy's potential growth rate, creating inflationary pressures.
The global reach of U.S. consumer spending and the high reliance of both Europe and Japan on international trade make this outcome seem especially improbable. And even if it did begin to happen, both the European and Japanese central banks would vigorously hike interest rates to reduce growth and prevent an inflationary outbreak.
In other words, if there was a surge in relative growth in Europe and Japan, it would probably be very short-lived.
Recent figures seem more supportive of the synchronization story. Japan's third-quarter growth of two per cent was below expectations, prompting the Bank of Japan to downgrade its outlook. European growth is also disappointing, especially in France and Italy, and leading indicators point to more sluggish growth ahead, although Germany is beating expectations.
Meanwhile, exports have slowed in Taiwan, Singapore and South Korea, key bellwethers of the global economy.
What this all means is that expectations of higher interest rates for Japan and Europe are also likely to be scaled back in coming months. Once these second-round effects are taken onboard, traders will begin to focus less on the relative performance of the major economies, and more on the overall economic performance of the world.
An appreciable slowdown at the global level will then mean increased default risk, lower commodity prices and exchange rate declines in the emerging markets - a recipe for U.S. dollar strength, not weakness.
The bottom line?
The world economy is at a key cyclical turning point, and it is common for foreign exchange rates to be volatile in such circumstances.
Look for the emergence of a more synchronized story for the world economy in the next couple of months, and a firmer U.S. dollar.
(Stephen Poloz is a senior vice-president and chief economist for Export Development Canada. He can be reached at spoloz@edc.ca)
