Hamish McRae: Dollar faces short-term jitters, but in the long run there's no need to worry about the US

What goes up must come down, but how quickly and how soon?

What goes up must come down, but how quickly and how soon?

The possibility of a sudden collapse of the dollar has entered the chat-rooms of the financial markets. No one as far as I know is predicting it as a serious odds-on chance. But the markets are noting that the dollar is at a three-month "low" against the euro, that the hi-tech enthusiasm that helped propel the dollar to its recent heights has by no means returned, and particularly that the current account deficit of the US is as wide as ever. That deficit requires a continuing flow of investment funds into the US and those funds will only keep a-flowing if the investment opportunities are thought to have diminished.

So there is at least a respectable case to be made for caution. Yesterday, as it happened, the caution broke out in another spurt of dollar weakness, and while a few days of the dollar heading south do not herald a collapse, the gradual perception that the peak might have been reached is itself likely to become self-reinforcing.

The dollar has certainly had an extraordinary run over the past six years, as indeed has sterling. Market levels of anything can be made to look extreme or reasonable by choosing the appropriate base, but as you can see from the graph, both the pound and the dollar are close to the top of their six-year range. The yen, on that six-year view, is off a bit and the euro (and its precursor currencies) is off a lot.

Come back to that in a moment and consider the main reason why the dollar has held up in recent months, the perceived strength of the US recovery – charted just below. The bounce back in the first part of this year has been terrific. The first three months saw just about as good a quarter as any at the height of the boom: around 1.4 per cent quarter on quarter, or nearly 6 per cent at an annual rate. That is the good news.

The bad news is that things will not continue at that pace. The primary reason is that much of the demand was a bounce in stocks. Inventories had been run right down during the summer and further post-11 September, and when companies found themselves short of stocks, demand flipped up. But investment spending has collapsed. Indeed it is worse now than it was during the early 1990s recession. As a result, while consumers have kept their spending up, total final demand is still growing at less than 2 per cent a year.

So where is growth going to come from? Not investment – there is a still a backlog of under-employed investment assets, for most of the boom was in high-technology kit. You can pick that up second-hand so why bother to buy new?

Not consumers – they have done a great job keeping things going and borrowing to do so. Sooner or later they will have to repair their personal balance sheets. But now the best hope is that they will keep spending up and rebuild their savings only gradually. Another consumer boom is not on the horizon, even if it were desirable.

Not housing. Don Straszheim, the independent economist in California who has called this US cycle particularly well, notes that housing has remained at high levels throughout this cycle, unlike previous ones. That has been great, for housing is always a powerful force sustaining demand; but it is not so great in the future for it is not going to rise much from here.

There is not much else ... except exports. Intellectually, you can make a good case that this would be the optimal way for the US to recover, for it would correct the current account deficit.

But exports are not going to climb with the dollar at its present level. Besides, if they did that might help the US but not the rest of the world.

So what will happen? Here are three propositions.

Proposition one is that in the next six to nine months the currency markets will be driven by perceptions of relative growth. The case, made above, that the US will not grow very quickly could also be applied to the eurozone, to the UK, to Japan in spades, to emerging East Asia and so on. If there are good reasons to have not much confidence in the dollar there are similar reasons to be wary of the euro, of sterling and of the yen. Watch the trends in each economy and make your bets.

Proposition two is that the dollar and the pound are both towards the top of their cyclical range and therefore on a four to five-year view it is sensible to expect them to fall back. But unless there is some external shock, this fall is likely to be 10 to 15 per cent rather than the 30 per cent they have appreciated over the last six years. The fall will be limited because of the next proposition.

Proposition three is that sterling and the dollar are both on a long-term upward move that will last a generation or more. (If sterling were to join the euro, the upward move would take place in the form of higher inflation instead of a rising currency.) This is because these economies, for demographic and other structural reasons, are likely to grow rather faster over the next 30 years than either the eurozone or Japan.

None of these propositions can be proved and they should be seen as a background framework for people to fit their ideas rather than tablets in stone. But if they are broadly right the consequences will be that the dollar will indeed become somewhat weaker in the medium term, but not catastrophically so. On a long view it will tend to strengthen. And the pound? Pretty much the same.