The Upshot of the Dollar's Fall

The dollar's descent to record lows has many market players fretting, but there are positives, too. Here's what you need to know

by Ben Steverman

The U.S. dollar fell to an all-time low Nov. 7, pushed over the edge by some off-the-cuff comments from Chinese officials.

But in the complex world of currency markets, things are not always as they appear. While a dollar in the dumps might look like a stain on U.S. pride and prestige, it might also be good news for American consumers, workers, and companies.

Here are several key lessons to learn from the dollar's slide:

1. The U.S. dollar really did hit a historic milestone on Nov. 7.

The dollar has been hitting record lows against the euro for years, but those records aren't very surprising because the euro is a new kid on the block, only created in 1999. On Nov. 7, the dollar hit a true milestone when it surpassed the spring of 1995 low against the Deutsche Mark, the equivalent of about $1.455 to $1.457, according to Marc Chandler, chief foreign exchange strategist at Brown Brothers Harriman.

On Nov. 7 the euro hit a high of $1.473 before pulling back a bit by the end of the day. At the end of the day, the euro was up 0.57%, to $1.4641.

2. Ignore the loose talk.

The dollar's plunge started when some Chinese central bank officials were quoted suggesting China would be diversifying its $1.4 trillion in foreign currency reserves, moving away from dollar holdings. But Chandler says those officials shouldn't have been taken seriously because they have little power: It would be like the mayor of Milwaukee making comments on the war in Iraq, he says.

Many already assumed China and other Asian central banks were diversifying their holdings, but they're not necessarily selling dollars, just buying extra euros. "This is a question of psychology," Chandler says. The Chinese comments "gave market participants an excuse to do what they wanted to do." Also, says Standard & Poor's European economist Jean-Michel Six, "There is a bit of political posturing here." China is pushing back on U.S. demands that it revalue its currency. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

One Chinese official was quoted saying the dollar is "losing its status as the world currency." There's not a lot of evidence for this contention, Chandler says. Despite the drop in the dollar's value, commodities such as oil and wheat are still traded all around the world in U.S. currency. U.S. Treasury bills are still a popular safe haven for investors all over the world. Treasury prices actually rose on Nov. 7.

3. So why did the dollar fall?

Look at economic fundamentals. Money moves across borders, chasing extra returns. So currencies tend to rise when the markets expect strong economic growth and to fall when a slowdown may be coming.

This economic strength or weakness is reflected in yields on bonds and interest rates. Right now, Keith Hembre, chief economist at First American Funds, says the bond markets seem to expect many more interest rate cuts from the Federal Reserve in the next several months. That means the markets also are expecting a deep slowdown in the U.S. So it's no surprise that investors are moving money out of dollars and into other currencies that will give them better returns.

4. Will the dollar keep falling?

It's hard to say, but "there is a lot of bad news that's already priced into the market," Hembre says. In other words, expectations in the bond market are already so low for the U.S. economy that they're unlikely to fall all that much further.

Chandler expects the dollar to keep falling until the end of the year but then rebound next year.

Andrew Bernard, professor of international economics at Dartmouth College's Tuck School of Business, warns it's very hard to predict currency movements in the near term. But don't expect the dollar to revive "until the U.S. economy starts picking up again," he says.