Economics: The euro traded at a new high against the dollar at the turn of the year, and sentiment towards the US currency was generally very negative at that time - this view was echoed by the Economist with a front cover shot of a dollar bill being eaten by a caterpillar.
Many commentators focused on the large US trade imbalance, and argued that the euro would appreciate towards $1.40 or $1.50 over the succeeding months. In the event, the euro promptly fell sharply, from just under $1.37 to a low of $1.2750 in early February, although it did rally from there, again trading up around $1.35 in mid-March, on the back of a pick-up in speculative buying.
The past few weeks have seen another reversal, however, which has taken the euro back down to $1.30 and there are a number of factors now conspiring to support the dollar and weaken the single currency, opening up the prospect of further falls.
These factors certainly do not include any change in the trend of the US trade deficit, which has continued its relentless climb. American imports now regularly exceed exports by over $55 billion (€42.4 million) a month, which represents a marked deterioration - the trade deficit in the latter months of 2003 was some $40 billion a month. This increase in the deficit has occurred despite a substantial dollar fall over the past three years. This depreciation has boosted US exports to some degree (exports rose by 10 per cent in 2004), but has done little to crimp the US demand for foreign products - imports rose by 18 per cent last year.
Clearly, economic growth is far more important than currency moves in determining trade balances, and the prime cause of the trade deficit is that the US economy has grown far faster than most of the developed world for the past decade.
Consequently, the US has only recorded a balance of payments surplus in one year out of the past 20.
Yet this tendency to chronic deficits has not resulted in persistent dollar weakness - the dollar has rallied strongly for years at a time despite such deficits, so there is no automatic link between a country's trade position and its currency.
What matters is the funding of any deficit and that brings us to the key issue - the dollar can rise despite its record trade shortfall, depending on the scale of capital flows into the US.
In that respect, the most recent data, capturing the fourth-quarter of 2004, is instructive. The US recorded a current account deficit of $188 billion in the quarter, equivalent to over 6 per cent of US GDP if replicated over a calendar year.
A recipe for a dollar fall, one might think, but there was an inflow of $218 billion in private capital over the same period, so private investors were more than willing to cover the trade shortfall. This inflow included $36 billion of foreign direct investment and over $180 billion in portfolio investments, including some $170 billion purchases of US corporate bonds and equities.
In addition, foreign central banks also bought US assets, largely short-term government bonds, to the tune of $82 billion, bringing the total capital inflow to an extraordinary $300 billion. This not only undermines the notion that the dollar's main support comes from Asian central banks but also suggests that foreign investors have not lost their appetite for US assets.
One shouldn't forget US investors, however, and the fourth-quarter figures also recorded a large increase in foreign direct investment outflows - US companies spent $100 billion in foreign investment in just three months. This is much higher than normal, but again illustrates that the popular explanation for any dollar weakness - that it reflects excessive spending by US consumers - is a simplification as it ignores the fact that US companies can invest abroad to achieve higher returns than at home while funding this cheaply by attracting foreign savings at a low rate of interest.
The prospective return on investing in the US is obviously important in determining the scale of capital inflows, and the recent upturn no doubt reflects higher interest rates in the US; short-term rates moved from 1 per cent last June to 2.75 per cent.
Moreover, longer-term bond yields have also begun to rise because the market is nervous that the Fed will shift to a more aggressive tightening mode.
So higher US yields may well be supportive of the dollar in general, and the euro could also be hurt by domestic developments in Europe. Growth in the euro zone remains lacklustre at best, but the ECB is worried about the pace of bank lending. This upturn in borrowing is not translating into higher consumer spending, but is pushing up house prices and funding the purchase of foreign assets.
The way to stop higher interest rates is clear enough, but it is difficult for the ECB to tighten monetary policy in the absence of a more pronounced economic upturn. This combination of loose monetary policy and excessive credit creation is a recipe for currency weakness, which could help to push the euro-dollar rate lower over the coming months.
