Why the Dollar Won't Collapse Against the Euro

By James Anderson  OCT 09, 2009 3:20 PM

Their problems are just as bad as America's.


Editor's Note: This was posted in real-time on our Buzz & Banter. It is being republished here for the benefit of the Minyanville community.

Professor Krueger’s excellent Buzz post yesterday really crystallized some of my concerns about the dollar, so I decided to dig in a little on the Dollar Index (DXY) and trade imbalances.

The Dollar Index was created by the Federal Reserve in 1973 to provide a trade-weighted average of the US dollar as it freely floated against global currencies. In 1973,10 currencies were used, but after the creation of the Euro, West German, French, Italian, Dutch, and Belgian currencies were combined in the Euro. Presently, there are six currencies in the DXY. The weights are as follows:

If you're thinking to yourself that this doesn’t exactly represent your view of the current global economy, welcome to the club. The DXY is calculated every few seconds by the ICE exchange for their Dollar Index futures product. Since the first trading of DXY futures in 1985, it adjusted only once, after the formation of the Euro. Looking in a simplistic way at the six components, there are four in manufacturing, one in hidden bank accounts, one in natural resources, and none in cheap labor.

Let’s look at trade surpluses and deficits. The top-ten trade deficits are listed below:

Analyzing the list: China -- cheap labor; Japan, Germany, Ireland, and Italy -- high-quality manufactured goods, drugs, etc.; everybody else -- energy. China is clearly the 800-pound gorilla in the room, and since it is, it’s not letting its currency strengthen. The dollar is weak against the yen, euro, and Canadian dollar. Anything else on the list doesn’t matter.

This data comes from the Census Bureau. Click here to see it.

Now let’s look at trade surpluses. The top-ten trade surpluses are listed below:

It's a mixture, but what I find interesting is that Australia and Brazil -- with two of the strongest currencies against the dollar this year -- actually run trade deficits with the United States.

Professor Kruger’s point -- that natural resource-rich currencies are the strongest against the dollar and may continue to strengthen -- seems very logical. But with the exception of Canada, we don’t run trade deficits with these countries. Only Canada is a component of DXY, so if the Brazilian and Australian currencies continue to strengthen, there will be no effect on the index.

Other than the natural-resource countries, what currencies can the dollar collapse against?

Not China -- they’re not playing the game. The euro? Look at those nice trade surpluses that Germany, Ireland, and Italy have. Are they willing to let the Euro climb to 2.00 or 2.50, and depress their already-weak economies to give American manufacturers a chance to take market share away from them? I don’t see that happening. How strong can the yen get? That I'm not sure of, but it's only 13.6% of DXY versus 77.3% for all the European currencies combined.

I just can’t see a collapse of the dollar against the euro when their problems are just as bad as ours. My thoughts after doing this analysis are that the weak dollar is too crowded a trade, that DXY is probably close to a bottom, and finally, that I'm going to start looking into Canadian stocks and maybe bank accounts.

No positions in stocks mentioned.

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