This week we saw the U.S. dollar take another tumble, to a three-year low.

The greenback was already under pressure but it weakened further after remarks made on Wednesday by U.S. Treasury Secretary Steve Mnuchin and U.S. Commerce Secretary Wilbur Ross at the World Economic Forum Annual Meeting in Davos, Switzerland. Their comments suggested that a weaker dollar is good for trade and good for the U.S., and that they are not concerned about the dollar in the short-term.

The market decided to take the dollar even lower after statements made by European Central Bank President Mario Draghi this week that didn't seem to show concern about the quickly rising euro.

The current dollar weakness is truly a conundrum. It is happening in the midst of a strong U.S. economic recovery with a boost from upcoming tax cuts, record stock prices, higher U.S. Treasury yields and three rate hikes penciled in this year by the U.S. Federal Reserve.

While the rest of the world is still recovering from low points in their economies, we have to wonder who could be selling the U.S. dollar so aggressively.

The sense we get is that, given the ever-so-strong “America First” verbiage by President Trump, foreign central banks and investors are starting to diversify out of their long dollar positions into the euro and other major currencies. The amount of foreign exchange reserves held by the world's central banks is much larger than any of the largest financial institutions or fund managers in the world - hence if central banks sell the dollar, that would certainly prompt an outright weakening of the currency.

Let's remember that foreign central banks' massive holdings of the U.S. dollar and U.S. Treasuries are actually funding our country's budget deficit. Our creditors may decide at any time that they do not want to continue funding our deficit. If that happens, they can sell the dollar or U.S. Treasuries at any time, leading to higher yields. China, in fact, has recently made noise about selling Treasuries, or at least not buying any more.

So is a weaker dollar better or worse for the U.S. economy and the global economic recovery?

My View: While dollar selling may have started due to disapproving sentiment towards the administration's protectionist rhetoric, the reality is that a weaker dollar actually does bolster trade policy - favoring U.S. exporters. It also makes it easier for the Federal Reserve to achieve its desired 2 percent inflation target, due to import price inflation, and it could result in the Fed raising rates faster than anticipated.

That being said, if the dollar were to experience a free fall, and U.S. yields shot up, it would be detrimental not only for the U.S. but also for the rest of the world:

  • Our budget deficit would be more expensive to fund because of higher interest rates – not a good situation with the predicted increase in the deficit due to the recently passed tax cuts.
  • Other major countries, like the eurozone, China and Japan, are primarily net-exporting nations. A sudden surge in their currencies would substantially deteriorate their terms of trade.
  • And it would also result in their current, sensitive deflationary state being exacerbated and delay their recoveries.

Free market principles are the bedrock of central bank policy. But since the dollar's weakening is so counter-intuitive to economics, we are certainly watching out for any unintended consequences.

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