How will the US dollar move now?

There are essentially two schools of thought regarding how the dollar might behave after the hostilities in Iraq have come to an end.

Dollar bulls point to the prospect of a post-war economic recovery, which should help lift both stock prices and the dollar significantly higher. Dollar bears point to ongoing concerns regarding the record deterioration of the U.S. current-account deficit and argue that this will continue to exert downward pressure on the dollar.

Others see that the world economy is undergoing a total regime change with major long-term lasting effects. This camp believes that the previous uptrend cycle in the dollar was solely a function of increased US productivity and that the immediate consequence of the Iraq war is likely to be a slow down in US productivity and this could bring additional pressure on the US currency.

They cite the following reasons: (1) Greater security efforts will likely impede free flow of goods, people and innovative ideas and thus slow the globalization trend (2) Recent political rift is likely to impact free trade talks between the US and Europe (3) Political conflicts is likely to make US companies relocate their operations from low-cost less secure countries to high-cost more secure countries (4) Diversion of scarce resources from the private sector to the government sector due to more spending on US defense and security (5) Reduced willingness of individuals and companies to take on risks as well as investors to provide capital for risky startups and venture capital.

This on-going debate about whether this quick victory in Iraq will help the US economy avert a renewed slide into recession will probably continue with us until the end of the second quarter. Recent evidence shows that very few analysts see the economy dashing forth from its current painfully slow growth path.

For example, in a survey conducted by the Wall Street Journal in April, several economists have revised down their estimates of US economic growth in the first half of the year. The consensus expectation for Q1 GDP growth is 1.6% and for Q2, the estimate is 2.2%.

Many believe that even if oil prices were to decline further, lifting consumer and producer confidence, the likely result would be to merely take the economy to where it was 6 months back, which is a slow growth track, not the racing growth path of the mid 1990s.

The counter argument would be that the economy will respond to the massive fiscal and monetary stimulus after the war is over, and we will see much better times going forward. Federal Reserve Bank Chairman Greenspan spoke last week, but he gave nothing new to cheer about, saying the full impact of the war will not be known until it is over.

The reaction from the financial markets about the latest and quick developments in the war clearly shows that this outcome has been well priced in. After being riveted to the media news for almost 3 weeks, it is now clear that the Iraqi regime has fled, leaving only sporadic resistance across the country. Consequently, the USD managed only a feeble rally, and indeed, attention quickly returned to the underlying economic fundamentals.

Overall, the war in Iraq is less of an immediate factor that will determine the future course of global growth and profitability. Economic and corporate fundamentals are consequently becoming more significant and these thus far do not paint a good picture at least in the short-term despite better than expected economic indicators seen last week.

Better-than-expected US Trade data (USD 40.3 billion versus 42.0 billion expected), lower-than-expected Jobless claims (405,000 versus 425,000), and strong Retail Sales (which rose 2.1% in March against expectations of +0.6%) all supported the dollar marginally. US Treasury Secretary John Snow had indicated that he continues to be an advocate of a strong dollar policy. This is however taken by the market as mere rhetoric.

The markets will be watching how the US will define its foreign policy beyond Iraq. There could be a period of lower volatility in the FX markets as traders reassess the implications of the war to the economy.

There is a wide spread belief that the medium-term downtrend for the dollar is not over, and until something significant and positive happens to change this perception, many tend to think that any recovery in the USD will be short-lived.