One of the most important things to realize is that the dollar has been free-floating for only about 35 years. Prior to that it was pegged to gold. With the little history we have, we know that the cycles of strengthening and weakening are fairly long -- 7 to 10 years. Right now we're in only year three of a weakening cycle.How do you explain the recent strength?
The dollar is up only a modest amount. Measured by the currencies of the countries we trade with, it's up 13% this year, but it's still down 25% from the '02 peak. Look at the stock market, which rose for 20 years. There were times when prices fell. It's the same with currencies -- the longer-term trend suggests weakness. We're in a countertrend.What is causing this countertrend?
First, look at how far the dollar had fallen already. By the end of last year it was down 40% against the euro and 25% against the yen. It fell too much, too fast -- and the countertrend corrects that. Another factor is oil, which is priced in dollars. Every petroleum-importing nation needs to purchase dollars to purchase oil. So higher oil prices mean more dollars are floating around abroad. At some point foreigners may not want to hold so many dollars, and that could lead to a sell-off.So the rally is not sustainable?
Correct. The dollar will weaken next year against the developed nations' currencies and then the rest of the developing nations in 2007 and 2008. Developing countries, such as China and Mexico, must be forced to revalue. [China has made one small revaluation, but has resisted further changes.]
I think we can make China revalue, and we have already started. This is less an economic deal than a political deal. The U.S. and the rest of the G-7 will start to put up trade barriers. Once we get a more meaningful revaluation with China, I believe the rest of the Pacific Rim countries will follow.
More of our trade deficit is caused by gross undervaluations in foreign currencies than our lack of competitiveness. If those currencies were allowed to float, they would undoubtedly rise. Sure, the dollar would weaken, but that would give our exporters a big boost.What about the impact of interest rates on the dollar?
While U.S. rates are a good deal higher than in Europe and Japan, capital does not always flow to the currency that offers the highest rates. We've been higher than the yen forever, and there have been times when the yen has strengthened against the dollar. It's not just the differential in interest rates but how much that differential is changing.
The real question, though, is whose rates will rise more? If U.S. growth continues at the same rate as this year, and Japan's and Europe's growth accelerates, it's a good bet their interest rates will go up more. The yield differential might start to close even if our rates are higher. Japan is considering tightening moves, and that would strengthen the yen. It also looks as if euro rates might start to go up, too, which also means the dollar will be slightly less attractive.